Financial Restructuring in Corporations

1
Financial Restructuring in Corporations

• Dr. Khaled F. Sherif
• Sector Manager
• Europe and Central Asia Department
• The World Bank
• Washington D.C.
• http//www.ksherif.com

2
Why Do Firms Fail?

• Corporate failure occurs when the following
  performance patterns exist
• Firm performance never rises above a poor
  level
• Firm shoots up to very high levels of performance
  before crashing down
• Firm performance partially collapses, followed by
  a relatively longer plateau period of sub-par
  performance, and then rapid decline into
  insolvency.

3
Processes Resulting in Corporate Failure

• There are at least two primary failure processes

UNSTRESSED
A relatively rapid, unexpeced failure in which
financial stress (proxied by accounting numbers)
is not evident
STRESSED
Relatively long duration in which financial
stress is evident
4
Corporate Restructuring

• There is always a step company makes before
  filing for bankruptcy. This step is called
  corporate restructuring.
• The aim of corporate restructuring is to
  rehabilitate financially distressed company.
• Corporate restructuring takes place through
• Government involvement by utilizing such
  restructuring vehicles as establishment of Asset
  Management Companies, Deposit Insurance
  Corporations, Corporate Restructuring Funds, etc.
• Company management involvement by changing firm's
  strategy and restructuring its financial
  statements.

5
Why Restructure?

• Why does a firm face a need to restructure?

Firm is overleveraged
Firm is underleveraged
Firm faces sluggish sales
Firm faces seasonal sale problems
Firm faces externalities
6
Review of Basic Ratios

• Before proceeding with approaches and methods to
  financial restructuring, lets summarize basic
  financial ratios

Liquidity ratios
Activity ratios
Leverage ratios
Profitability ratios
7
Leverage Ratios

• Nine ratios describe leverage. They all are an
  indication of how a firm gets its operating
  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

8
Financial Leverage Ratios

• Financial leverage ratios measure the funds
  supplied by owners (equity) as compared with the
  financing provided by the firms creditors
  (debt).
• Financial leverage is the use of debt to magnify
  return on equity (ROE) to shareholders.
• Equity, or owner-supplied funds, provide a margin
  of safety for creditors. Thus, the less equity,
  the more the risks of the enterprise to the
  creditors.
• To understand financial leverage we need to
  understand ratios between Debt to Total Assets
  and Debt to Equity

9
Sample Balance Sheet

• Company X Balance Sheet
• December 31, 2003 (000)

Current Assets Cash 200 Marketable
Securities 350 Accounts Receivable
200 Inventory 500 Prepaid Expenses
250 Total Current Assets 1,500 Fixed
Assets Land 4,500 Plant 9,000 Machinery
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 100 Maturing Bonds
100 Bonds 2,000 Loans 5,100 Total
Liabilities 8,000 Shareholder
s Equity 14,000 Total
Liabilities and Equity 22,000
10
Sample Income Statement

• Company X Income Statement
• Ending 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
11
Financial Leverage Ratios Debt Ratio

• The debt ratio is the ratio of total debt to
  total assets and measures the percentage of total
  funds provided by creditors
• DEBT RATIO
• Debt Ratio for Company X for the year 2003 is
  calculated as follows
• Debt Ratio 8,000 / 22,000 0.36

TOTAL DEBT
TOTAL ASSETS
12
Debt Ratio

• To see whether Company Xs Debt Ratio is an
  indicator of its good performance, we need to
  look at
• the historical trend of the ratio
• A comparison of the companys performance against
  other major players in the industry
• If Debt Ratio is rising, the company is
  developing a leverage problem
• If the debt ratio is falling, the company is
  investing more of its own resources to generate
  assets and is becoming less dependent on debts

13
Debt Ratio - Industry Graph
14
Example of Debt Ratio

• Debt Ratio of Company X has been improving from
  1997 to 2003. It went down from 0.61 to 0.36
  which means the company is less relying on debt
  to finance its assets.
• Compared to the Industry in 2003, the Company X
  is almost on par with the industry average Debt
  Ratio
• Company X 0.36
• Industry Average 0.37
• Company X has performed relatively well in 2003
  than in previous years compared to other major
  players in the industry - Company Y and Company Z.

15
Financial Leverage Ratios Debt to Equity Ratio

• The debt to equity ratio compares the amount of
  money borrowed from creditors to the amount of
  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

TOTAL DEBT
TOTAL EQUITY
16
Debt to Equity Ratio

• To see whether Company Xs Debt to Equity Ratio
  is an indicator of its good performance, we need
  to look at
• the historical trend of the ratio,
• the company compared with other major players in
  the industry
• If Debt to Equity Ratio is rising, the company is
  developing a leverage problem
• If the debt ratio is falling, the company is
  investing more of its owners resources to
  generate assets and is becoming less dependent on
  creditors

17
Debt to Equity Ratio - Industry Graph
18
Example of Debt to Equity Ratio

• Debt to Equity Ratio of Company X has been
  declining from 1997 to 2003
• It went down from 0.79 to 0.57
• This means the company has been changing its debt
  to equity mix with moving away from heavy debt
  borrowing to raising capital from shareholders
• The graph also shows that Company X has been
  overleveraged in 1997

19
Example of Debt to Equity Ratio

• Compared to the Industry in 2003, the Company X
  is performing slightly above the industry
  average, but has shown a persistent trend
  towards the industry average Debt to Equity Ratio
  
• Company X 0.57
• Industry Average 0.51
• Company X has performed better than Company Y in
  2003. Company Z shows signs of being
  underleveraged, which can be very risky

20
Decisions about Leverage

• Decisions about the use of leverage must balance
  higher expected returns against increased risk.
• Debt funding enables the owners to maintain
  control of the firm with a limited investment.
• If the firm earns more on the borrowed funds than
  it pays in interest, the return to the owners is
  magnified.

21
Decisions about Leverage
LOW LEVERAGE RATIOS
Indicate less risk of loss when the economy is in
a downturn, but lower expected returns when the
economy booms
HIGH LEVERAGE RATIOS
Indicate the risk of large losses, but also have
a chance of gaining high profits
22
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 and maximizes returns
23
Examples of Overleveraged and 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 costs are 40,000
• We will look at three scenarios where Debt to
  Equity ratios will be at 25, 100 and 400

What should the debt and equity mix be, and what
is it going to affect, and how?
24
Examples of Overleveraged and Underleveraged Firms

• Debt to Equity Ratio 25 100 400
• Net sales 150,000 150,000 150,000
• COGS 90,000 90,000 90,000
• Fixed Costs 40,000 40,000 40,000
• Interest Expense 1,600 4,000
  6,400
• Pretax Income 18,400 16,000 13,600
• Income tax (40) 7,360 6,400
  5,440
• Net Income 11,040 9,600 8,160
• Return on Equity 13.8 19.2
  40.8
• Debt (8 interest) 20,000 50,000 80,000
• Equity 80,000 50,000 20,000
• Total Capital 100,000 100,000 100,000

25
Examples of Overleveraged and Underleveraged Firms

• By looking at debt and equity mix, it is clear
  that underleveraged companies

Pay high interest expenses
Have low EBT
Pay less in taxes
Their net income is comparatively low
ROE is the highest, since there is an
over-reliance on debt
26
Examples of Overleveraged and Underleveraged Firms

• By looking at debt and equity mix, it is clear
  that overleveraged companies

Pay less in interest expenses
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
27
Examples of Overleveraged and Underleveraged Firms

• Overleveraged companies also have other
  obligations not shown here, such as payment of
  dividends to shareholders
• The more equity is raised through shareholders
  (stocks issued), the more firms have to pay out
  in dividends, thus reducing their retained
  earnings that can later be re-invested into
  business expansion

28
Causes for Financial Restructuring

• There are several instances where company
  management has to make a decision 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

29
Overleveraged Firm

• The problem of overleverage occurs when a firm
  has overborrowed debt from a bank on a consistent
  basis
• As a result, firm has a higher Debt to Equity
  Ratio
• Using debt to run a firm is a common practice,
  however, sometimes there is an over-reliance on
  debt
• Over-reliance on debt can be a factor in hurting
  the companys bottom line

30
Overleveraged Firm

• Overleveraging is acceptable in cases when a firm
  is undertaking expansion projects (buying new
  plant and equipment, investing into new
  technologies) that have high probability of
  higher expected returns, profits, and thus ROA
• When firms over-borrow debt on a consistent
  basis, and thus have profitability issues, the
  management has to consider Financial Restructuring

31
Overleveraged Firm

• If a firm is fully leveraged, it will not be able
  to borrow money
• A lower debt-equity ratio will make for easier
  loan negotiations in the event a firm needs to
  borrow money in the future
• Many financially distressed firms that
  restructure their debts either file for
  bankruptcy later or experience financial distress
  again
• This is because they remain overleveraged after
  the restructuring out-of-court restructurings
  leave firms with suboptimal capital structures

32
Overleveraged Firm

• Financial Restructuring in overleveraged firm can
  be implemented through

Issuing new stocks
Selling off unprofitable assets to pay off debt
Rent out equipment to pay off debt
Restructure debt (refinance LT debt with a lower
interest rate, if possible)
Debt to equity swap
33
Overleveraged Firm - Example

• Issuing new stocks (issue 50,000 in stocks to
  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

34
Underleveraged Firm

• The problem of underleverage arises when a firm
  has raised majority of its capital through stocks
• As a result, firm has a very low Debt to Equity
  Ratio
• With higher equity the firm has to improve its
  performance to keep the shareholders happy
• If firm pays dividends, it has to constantly
  allocate a portion of its profits towards
  dividends payable to shareholders

35
Underleveraged Firm

• Financial Restructuring in underleveraged firm
  can be implemented through

Buying back stocks for cash (if available)
Borrowing funds (debt) to buyback stocks to
attain the best debt to equity mix
Selling off unprofitable assets to buyback stocks
Renting out equipment to buyback stocks
36
Underleveraged Firm - Example

• Borrowing funds to buyback stocks (borrow 40,000
  in debt to buy back 40,000 worth of common
  shares)
• Before After
• Total Assets 100,000 98,080
• Total 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

37
Firm with Sluggish Sales
Sluggish sales can cause financial distress, as
they affect a companys cash flow
Sluggish sales are influenced by the line of
business a firm is in
Usually, firms face sluggish sales when they are
into big ticket items sale, or when the economy
is slow
As a result, companys working capital decreases
causing cash deficit
One of the areas most affected by sluggish sales
is piling of accounts receivable and the problem
of non-collection
Cash deficit forces firms management to take
alternative steps to raising cash through stock
issuance, debt borrowing or other
38
Firm with Sluggish Sales - Example

• Decrease in sales by 25,000 and 35,000.
  Original sales at 150,000.
• Before After After
• (sales down (sales down
• by 25,000) by 35,000)
• Total Assets 100,000 94,000 91,600
• Total Debt 50,000 50,000 50,000
• Total Equity 50,000 44,000 41,600
• Common Stocks 40,000 40,000 40,000
• Retained Earnings 10,000 4,000
  1,600
• Net Profit 9,600 3,600 1,200
• Debt 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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Firm with Sluggish Sales - Example

• The example showed that a slight drop in sales
  might completely change the financial picture of
  a firm
• Decline in profits causes drop in total assets
  (decrease in cash inflow) and equity (decrease in
  retained earnings)
• If not addressed timely, this might cause a
  problem of overleveraged firm

40
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

41
Firm with Sluggish Sales

• Financial Restructuring in a firm with slow sales
  can be implemented through

Different hedging techniques (to avoid or cover
currency 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,
providing discounts, or demanding prepayment)
Diversification of line of business (producing
fast selling products in parallel to compensate
slow sales and raise additional cash to use as a
working capital)
42
Firm with Sluggish Sales

• Why do companies attempt to hedge

There are risks peripheral to the central
business in which they operate
Companies do not exist in isolation hedging is
also used to improve or maintain the
competitiveness of the firm
Hedging is contingent on the preferences of the
firm's shareholders
43
Firm with Seasonal Sales

• Seasonal sales are attributive to firms in
  several industries such as farming, construction,
  businesses highly dependent on holidays, etc.
• The question is how to keep businesses viable
  when the season is out
• Similar techniques can be adopted as with
  sluggish sales
• In addition, firms with seasonal sales need to
  engage into other lines of businesses, to
  diversify and therefore reduce the risk, as well
  as to have an additional source for cash inflow

44
Firm with Seasonal Sales

• Seasonal pattern in sales affects company
  profits, and therefore, causes cash 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 show company sustainability

45
Firm with Seasonal Sales

• Financial Restructuring in a firm with seasonal
  sales can be implemented through
• Different hedging techniques
• Borrowing funds on line of credit to cover
  working capital gap during months of inactivity
• Diversification of line of business (producing
  products that have non-seasonal demand to
  compensate seasonal sales and raise additional
  cash for covering working capital gap)

46
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

47
Firm facing Externalities

• There are several techniques that companies can
  employ to reduce external risk
• 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

48
Conclusion

• Each firm is a unique entity, and there is no one
  road map for success
• Management should be aware of different
  techniques available when a company is in
  financial distress
• Each decision should be tailored to a firm taking
  into account specificity of the business
• Management has to look at advantages and
  disadvantages each decision has.