Financial Restruct

8/9/2019 Financial Restruct

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Financial Restructuring inFinancial Restructuring in

CorporationsCorporations

Dr. Khaled F. SherifDr. Khaled F. SherifSector ManagerSector Manager

Europe and Central Asia DepartmentEurope and Central Asia Department

The World BankThe World Bank

Washington D.C.Washington D.C.

http://www.ksherif.comhttp://www.ksherif.com


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Why Do Firms Fail?Why Do Firms Fail?

Corporate failure occurs when theCorporate failure occurs when thefollowing performance patterns exist:following performance patterns exist:

Firm performance never rises above a poorFirm performance never rises above a poorlevel;level;

Firm shoots up to very high levels ofFirm shoots up to very high levels ofperformance before crashing down;performance before crashing down;

Firm performance partially collapses,Firm performance partially collapses,followed by a relatively longer plateaufollowed by a relatively longer plateauperiod of subperiod of sub--par performance, and thenpar performance, and thenrapid decline into insolvency.rapid decline into insolvency.


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Processes Resulting inProcesses Resulting inCorporate FailureCorporate Failure

There are at least two primary failureThere are at least two primary failureprocesses:processes:

Relatively long duration in which financialstress is evident

STRESSEDSTRESSED

A relatively rapid, unexpeced failure in whichfinancial stress (proxied by accounting numbers)

is not evident

UNSTRESSEDUNSTRESSED


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Corporate RestructuringCorporate Restructuring

There is always a step company makes beforeThere is always a step company makes beforefiling for bankruptcy. This step is calledfiling for bankruptcy. This step is calledcorporate restructuring.corporate restructuring.

The aim of corporate restructuring is toThe aim of corporate restructuring is to

rehabilitate financially distressed company.rehabilitate financially distressed company. Corporate restructuring takes place through:Corporate restructuring takes place through:

Government involvement by utilizing suchGovernment involvement by utilizing suchrestructuring vehicles as establishment of Assetrestructuring vehicles as establishment of Asset

Management Companies, Deposit InsuranceManagement Companies, Deposit InsuranceCorporations, Corporate Restructuring Funds, etc.Corporations, Corporate Restructuring Funds, etc.

Company management involvement by changingCompany management involvement by changingfirm's strategy and restructuring its financialfirm's strategy and restructuring its financialstatements.statements.


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Why Restructure?Why Restructure?

Why does a firm face a need toWhy does a firm face a need torestructure?restructure?

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 RatiosReview of Basic Ratios

Before proceeding with approaches andBefore proceeding with approaches andmethods to financial restructuring, letsmethods to financial restructuring, letssummarize basic financial ratios:summarize basic financial ratios:

LiquidityLiquidityratiosratios

LeverageLeverageratiosratios

ActivityActivityratiosratios

ProfitabilityProfitabilityratiosratios


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Leverage RatiosLeverage Ratios

Nine ratios describe leverage. They allNine ratios describe leverage. They allare an indication of how a firm gets itsare an indication of how a firm gets itsoperating funds:operating funds: Collection PeriodCollection Period

Sales to InventorySales to Inventory

Assets to SalesAssets to Sales

Sales to Net Working CapitalSales to Net Working Capital

Accounts Payable to SalesAccounts Payable to Sales

Debt to EquityDebt to Equity

Current Debt to EquityCurrent Debt to Equity

Interest CoverageInterest Coverage

Debt ServicesDebt Services


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Financial Leverage RatiosFinancial Leverage Ratios

Financial leverage ratios measure the fundsFinancial leverage ratios measure the fundssupplied by owners (equity) as compared withsupplied by owners (equity) as compared withthe financing provided by the firms creditorsthe financing provided by the firms creditors(debt).(debt).

Financial leverage is the use of debt to magnifyFinancial leverage is the use of debt to magnifyreturn on equity (ROE) to shareholders.return on equity (ROE) to shareholders.

Equity, or ownerEquity, or owner--supplied funds, provide asupplied funds, provide amargin of safety for creditors. Thus, the lessmargin of safety for creditors. Thus, the lessequity, the more the risks of the enterprise toequity, the more the risks of the enterprise to

the creditors.the creditors. To understand financial leverage we need toTo understand financial leverage we need to

understand ratios between Debt to Total Assetsunderstand ratios between Debt to Total Assetsand Debt to Equityand Debt to Equity


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Sample Income StatementSample 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 1,000Gross 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 totalThe debt ratio is the ratio of total debt to totalassets and measures the percentage of totalassets and measures the percentage of totalfunds provided by creditors:funds provided by creditors:

DEBT RATIO =DEBT RATIO =

Debt Ratio for Company X for the year 2003 isDebt Ratio for Company X for the year 2003 iscalculated as followscalculated as follows

Debt Ratio = 8,000 / 22,000 = 0.36Debt Ratio = 8,000 / 22,000 = 0.36

Financial Leverage Ratios:Financial Leverage Ratios:Debt RatioDebt Ratio

TOTAL DEBT

TOTAL ASSETS


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Debt RatioDebt Ratio

To see whether Company Xs Debt RatioTo see whether Company Xs Debt Ratiois an indicator of its good performance,is an indicator of its good performance,we need to look at:we need to look at: the historical trend of the ratiothe historical trend of the ratio

A comparison of the companys performanceA comparison of the companys performanceagainst other major players in the industryagainst other major players in the industry

If Debt Ratio is rising, the company isIf Debt Ratio is rising, the company isdeveloping a leverage problemdeveloping a leverage problem

If the debt ratio is falling, the company isIf the debt ratio is falling, the company isinvesting more of its own resources toinvesting more of its own resources togenerate assets and is becoming lessgenerate assets and is becoming lessdependent on debtsdependent on debts


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Debt RatioDebt Ratio -- Industry GraphIndustry Graph

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o pany o pany Y

o pany Z Industry erage


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The debt to equity ratio compares the amount ofThe debt to equity ratio compares the amount ofmoney borrowed from creditors to the amountmoney borrowed from creditors to the amountof shareholders investment made within a firmof shareholders investment made within a firm

DEBT TO EQUIT RATIO =DEBT TO EQUIT RATIO =

Debt to Equity Ratio for Company X for the yearDebt to Equity Ratio for Company X for the year

2003 is calculated as follows2003 is calculated as follows

Debt To Equity Ratio = 8,000 / 14,000 = 0.5Debt To Equity Ratio = 8,000 / 14,000 = 0.5

Financial Leverage Ratios:Financial Leverage Ratios:Debt to Equity RatioDebt to Equity Ratio

TOTAL DEBT

TOTAL EQUITY


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Debt to Equity RatioDebt to Equity Ratio

To see whether Company Xs Debt toTo see whether Company Xs Debt toEquity Ratio is an indicator of its goodEquity Ratio is an indicator of its goodperformance, we need to look at:performance, we need to look at: the historical trend of the ratio,the historical trend of the ratio,

the company compared with other majorthe company compared with other majorplayers in the industryplayers in the industry

If Debt to Equity Ratio is rising, theIf Debt to Equity Ratio is rising, thecompany is developing a leveragecompany is developing a leverageproblemproblem

If the debt ratio is falling, the company isIf the debt ratio is falling, the company isinvesting more of its owners resources toinvesting more of its owners resources togenerate assets and is becoming lessgenerate assets and is becoming lessdependent on creditorsdependent on creditors


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Debt to Equity RatioDebt to Equity Ratio -- IndustryIndustryGraphGraph

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o pany o pany

o pany Industry era e


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Example of Debt to EquityExample of Debt to EquityRatioRatio

Debt to Equity Ratio of Company X hasDebt to Equity Ratio of Company X hasbeen declining from 199 to 2003been declining from 199 to 2003 It went down from 0. 9 to 0.5It went down from 0. 9 to 0.5

This means the company has beenThis means the company has beenchanging its debt to equity mix withchanging its debt to equity mix withmoving away from heavy debt borrowingmoving away from heavy debt borrowingto raising capital from shareholdersto raising capital from shareholders

The graph also shows that Company XThe graph also shows that Company Xhas been overleveraged in 199has been overleveraged in 199


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Example of Debt to EquityExample of Debt to EquityRatioRatio

Compared to the Industry in 2003, theCompared to the Industry in 2003, theCompany X is performing slightly aboveCompany X is performing slightly abovethe industry average, but has shown athe industry average, but has shown a

persistent trend towards the industrypersistent trend towards the industryaverage Debt to Equity Ratioaverage Debt to Equity Ratio

Company XCompany X 0.50.5

Industry AverageIndustry Average 0.510.51

Company X has performed better thanCompany X has performed better thanCompany in 2003. Company Z showsCompany in 2003. Company Z showssigns of being underleveraged, whichsigns of being underleveraged, whichcan be very riskycan be very risky


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Decisions about LeverageDecisions about Leverage

Decisions about the use of leverageDecisions about the use of leveragemust balance higher expected returnsmust balance higher expected returnsagainst increased risk.against increased risk.

Debt funding enables the owners to maintainDebt funding enables the owners to maintaincontrol of the firm with a limited investment.control of the firm with a limited investment.

If the firm earns more on the borrowed fundsIf the firm earns more on the borrowed fundsthan it pays in interest, the return to thethan it pays in interest, the return to the

owners is magnified.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 RATIOSLOW LEVERAGE RATIOS

Indicate the risk of large losses, but also have achance of gaining high profits

HIGH LEVERAGE RATIOSHIGH LEVERAGE RATIOS


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DebtDebt

EquityEquity

Too much Debt =Too much Debt =

Overleveraged firmOverleveraged firm

Too much Equity =Too much Equity =

Underleveraged firmUnderleveraged firm

The decision is a tradeoff between Risks and Returns.The decision is a tradeoff between Risks and Returns.A firm should adopt a policy that minimizes risks andA firm should adopt a policy that minimizes risks andmaximizes returnsmaximizes returns


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Examples of OverleveragedExamples of Overleveragedand Underleveraged Firmsand Underleveraged Firms

A firm needs to raise $100,000 in capitalA firm needs to raise $100,000 in capital

Company borrows at 8% per yearCompany borrows at 8% per year

Income taxes are at 40%Income taxes are at 40%

COGS is 60% of sales, and fixed costsCOGS is 60% of sales, and fixed costsare $40,000are $40,000

We will look at three scenarios whereWe will look at three scenarios whereDebt to Equity ratios will be at 25%,Debt to Equity ratios will be at 25%,100% and 400%100% and 400%

What should the debt and equity mix be, and what is itgoing to affect, and how?


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Debt to Equity RatioDebt to Equity Ratio 25%25% 100%100% 400%400%

Net sales 150,000 150,000 150,000COGS 90,000 90,000 90,000Fixed Costs 40,000 40,000 40,000

Interest 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


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By looking at debt and equity mix, it isBy looking at debt and equity mix, it isclear that underleveraged companies:clear 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


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By looking at debt and equity mix, it isBy looking at debt and equity mix, it isclear that overleveraged companies:clear 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


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Overleveraged companies also haveOverleveraged companies also haveother obligations not shown here, suchother obligations not shown here, suchas payment of dividends to shareholdersas payment of dividends to shareholders

The more equity is raised throughThe more equity is raised throughshareholders (stocks issued), the moreshareholders (stocks issued), the morefirms have to pay out in dividends, thusfirms have to pay out in dividends, thus

reducing their retained earnings that canreducing their retained earnings that canlater be relater be re--invested into businessinvested into businessexpansionexpansion


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Causes for FinancialCauses for FinancialRestructuringRestructuring

There are several instances whereThere are several instances wherecompany management has to make acompany management has to make adecision about Financial Restructuringdecision about Financial Restructuring

This includes cases when:This includes cases when: Firm is overleveragedFirm is overleveraged

Firm is underleveragedFirm is underleveraged

Firm faces sluggish salesFirm faces sluggish sales Firm faces seasonal sale problemsFirm faces seasonal sale problems

Firm faces externalitiesFirm faces externalities


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Overleveraged FirmOverleveraged Firm

Overleveraging is acceptable in casesOverleveraging is acceptable in caseswhen a firm is undertaking expansionwhen a firm is undertaking expansionprojects (buying new plant andprojects (buying new plant and

equipment, investing into newequipment, investing into newtechnologies) that have high probabilitytechnologies) that have high probabilityof higher expected returns, profits, andof higher expected returns, profits, andthus ROAthus ROA

When firms overWhen firms over--borrow debt on aborrow debt on aconsistent basis, and thus haveconsistent basis, and thus haveprofitability issues, the management hasprofitability issues, the management hasto consider Financial Restructuringto consider Financial Restructuring


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If a firm is fully leveraged, it will not be able toIf a firm is fully leveraged, it will not be able toborrow moneyborrow money

A lower debtA lower debt--equity ratio will make for easierequity ratio will make for easierloan negotiations in the event a firm needs toloan negotiations in the event a firm needs to

borrow money in the futureborrow money in the future Many financially distressed firms thatMany financially distressed firms that

restructure their debts either file for bankruptcyrestructure their debts either file for bankruptcylater or experience financial distress againlater or experience financial distress again

This is because they remain overleveraged afterThis is because they remain overleveraged afterthe restructuring; outthe restructuring; out--ofof--court restructuringscourt restructuringsleave firms with suboptimal capital structuresleave firms with suboptimal capital structures


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Financial Restructuring in overleveragedFinancial Restructuring in overleveragedfirm can be implemented throughfirm 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 FirmOverleveraged Firm -- ExampleExample

Issuing new stocksIssuing new stocks (issue $50,000 in stocks(issue $50,000 in stocksto pay off $50,000 in debt)to pay off $50,000 in debt)

BeforeBefore After After

Total Assets $100,000 $102,400Total Debt $80,000 $30,000

Total Equity $20,000 $ 2,400

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 FirmUnderleveraged Firm

The problem of underleverage arises when aThe problem of underleverage arises when afirm has raised majority of its capital throughfirm has raised majority of its capital throughstocksstocks

As a result, firm has a very low Debt to EquityAs a result, firm has a very low Debt to Equity

RatioRatio

With higher equity the firm has to improve itsWith higher equity the firm has to improve itsperformance to keep the shareholders happyperformance to keep the shareholders happy

If firm pays dividends, it has to constantlyIf firm pays dividends, it has to constantlyallocate a portion of its profits towardsallocate a portion of its profits towardsdividends payable to shareholdersdividends payable to shareholders


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Underleveraged FirmUnderleveraged Firm

Financial Restructuring in underleveragedFinancial Restructuring in underleveragedfirm can be implemented throughfirm 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


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Underleveraged FirmUnderleveraged Firm --ExampleExample

Borrowing funds to buyback stocksBorrowing funds to buyback stocks (borrow(borrow$40,000 in debt to buy back $40,000 worth of$40,000 in debt to buy back $40,000 worth ofcommon shares)common shares)

BeforeBefore After 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 SalesFirm 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 SalesFirm with Sluggish Sales --ExampleExample

Decrease in sales by $25,000 and $35,000. OriginalDecrease in sales by $25,000 and $35,000. Originalsales at $150,000.sales at $150,000.

BeforeBefore After After AfterAfter(sales down(sales down (sales down(sales downby $25,000)by $25,000) by $35,000)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 inThe example showed that a slight drop insales might completely change thesales might completely change thefinancial picture of a firmfinancial picture of a firm

Decline in profits causes drop in totalDecline in profits causes drop in totalassets (decrease in cash inflow) andassets (decrease in cash inflow) andequity (decrease in retained earnings)equity (decrease in retained earnings)

If not addressed timely, this might causeIf not addressed timely, this might causea problem of overleveraged firma problem of overleveraged firm


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Current AssetsCurrent Assets Current LiabilitiesCurrent Liabilities(remain unchanged)(remain unchanged)

Fixed AssetsFixed Assets Long Term LiabilitiesLong Term Liabilities(remain unchanged)(remain unchanged) (remain unchanged)(remain unchanged)

Equity/CapitalEquity/Capital

TOTAL ASSETSTOTAL ASSETS TOTAL LIABILITIES + EQUITYTOTAL LIABILITIES + EQUITY

Working Capital = CAWorking Capital = CA CLCL


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Financial Restructuring in a firm with slow salesFinancial Restructuring in a firm with slow salescan be implemented through:can be implemented through:

Different hedging techniques (to avoid or covercurrency risk, interest rate risk, etc.)

Borrowing funds on line of credit to cover workingcapital 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 hedgeWhy do companies attempt to hedge

Hedging is contingent on the preferences ofHedging is contingent on the preferences ofthe firm's shareholdersthe firm's shareholders

There are risks peripheral to the centralThere are risks peripheral to the centralbusiness in which they operatebusiness in which they operate

Companies do not exist in isolation; hedgingCompanies do not exist in isolation; hedgingis also used to improve or maintain theis also used to improve or maintain the

competitiveness of the firmcompetitiveness of the firm


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Firm with Seasonal SalesFirm with Seasonal Sales

Seasonal sales are attributive to firms inSeasonal sales are attributive to firms inseveral industries such as farming,several industries such as farming,construction, businesses highly dependentconstruction, businesses highly dependenton holidays, etc.on holidays, etc.

The question is how to keep businessesThe question is how to keep businessesviable when the season is outviable when the season is out

Similar techniques can be adopted as withSimilar techniques can be adopted as withsluggish salessluggish sales

In addition, firms with seasonal sales needIn addition, firms with seasonal sales needto engage into other lines of businesses, toto engage into other lines of businesses, todiversify and therefore reduce the risk, asdiversify and therefore reduce the risk, aswell as to have an additional source for cashwell as to have an additional source for cashinflowinflow


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Seasonal pattern in sales affectsSeasonal pattern in sales affectscompany profits, and therefore, causescompany profits, and therefore, causescash flow deficit during later monthscash flow deficit during later months

Cash flow deficit causes working capitalCash flow deficit causes working capital

gapgap Working capital gap slows downWorking capital gap slows down

company growthcompany growth

In order to raise cash the company canIn order to raise cash the company can

borrow long term debt or issue stocks;borrow long term debt or issue stocks;before doing so, however, it should showbefore doing so, however, it should showcompany sustainabilitycompany sustainability


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Financial Restructuring in a firm withFinancial Restructuring in a firm withseasonal sales can be implementedseasonal sales can be implementedthroughthrough Different hedging techniquesDifferent hedging techniques

Borrowing funds on line of credit to coverBorrowing funds on line of credit to coverworking capital gap during months ofworking capital gap during months ofinactivityinactivity

Diversification of line of business (producingDiversification of line of business (producingproducts that have nonproducts that have non--seasonal demand toseasonal demand to

compensate seasonal sales and raisecompensate seasonal sales and raiseadditional cash for covering working capitaladditional cash for covering working capitalgap)gap)


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Firm facing ExternalitiesFirm facing Externalities

Firms face externalities such as:Firms face externalities such as: Changes in currency exchange ratesChanges in currency exchange rates

Changes in global interest ratesChanges in global interest rates

Fluctuations in prices for imported rawFluctuations in prices for imported raw

materialsmaterials This causes firms product prices to goThis causes firms product prices to go

upup

Pushing price increases to consumersPushing price increases to consumers

usually affects the companys sales;usually affects the companys sales;resulting in sluggish salesresulting in sluggish sales


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Firm facing ExternalitiesFirm facing Externalities

There are several techniques thatThere are several techniques thatcompanies can employ to reduce externalcompanies can employ to reduce externalriskrisk

This includesThis includes different techniques ofdifferent techniques of

hedging:hedging: Buying raw materials in abundance to hedgeBuying raw materials in abundance to hedge

price fluctuations of imported materials.price fluctuations of imported materials.

Currency hedgingCurrency hedging

Interest rate hedgingInterest rate hedging Future and forward contractsFuture and forward contracts


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ConclusionConclusion

Each firm is a unique entity, and there isEach firm is a unique entity, and there isno one road map for successno one road map for success

Management should be aware of differentManagement should be aware of differenttechniques available when a company istechniques available when a company is

in financial distressin financial distress Each decision should be tailored to a firmEach decision should be tailored to a firm

taking into account specificity of thetaking into account specificity of thebusinessbusiness

Management has to look at advantagesManagement has to look at advantagesand disadvantages each decision has.and disadvantages each decision has.

Documents

Financial Restruct