Financial Distress

Financial distress refers to a condition in which a company cannot meet, or has difficulty paying
off, its financial obligations to its creditors, typically due to high fixed costs, illiquid assets, or
revenues sensitive to economic downturns.

The list of events is almost endless and may create financial distress, but here are some

examples:

➢ Dividend reductions
➢ Plant closings

➢ Losses
➢ Layoffs
➢ CEO resignations

➢ Plummeting stock prices

Break down the definition:

Our definition of financial distress can be expanded somewhat by linking it to insolvency. This
definition has two general themes: stocks and flows.
Stock-based insolvency occurs when a firm has negative net worth, so the value of assets is less
than the value of its debts.
Flow-based insolvency occurs when operating cash flow is insufficient to meet current
obligations. Flow-based insolvency refers to the inability to pay one’s debts. Insolvency may lead
to bankruptcy.

Financial Distress- Consequences

Financial distress is a situation where a firm’s operating cash flows are not sufficient to satisfy
current obligations (such as trade credits or interest expenses) and the firm is forced to take
corrective
action.1 Financial distress may lead a firm to default on a contract, and it may involve financial
restructuring between the firm, its creditors, and its equity investors. Usually, the firm is forced to
take actions that it would not have taken if it had sufficient cash flow.

Firms deal with financial distress in several ways, such as these:

1. Selling major assets.

2. Merging with another firm.

3. Reducing capital spending and research and development.

4. Issuing new securities.

5. Negotiating with banks and other creditors.

6. Exchanging debt for equity.

7. Filing for bankruptcy.

Items (1), (2), and (3) concern the firm’s assets. Items (4), (5), (6), and (7) involve the right side of the
firm’s balance sheet and are examples of financial restructuring. Financial distress may involve both asset
restructuring and financial restructuring.

Here we discuss about financial restructuring.

Bankruptcy Liquidation and Reorganization- Definition

Bankruptcy is a legal proceeding and can be done voluntarily with the corporation filing the
petition or involuntarily with the creditors filing the petition.

Firms that cannot or choose not to make contractually required payments to creditors have two
basic options as the types of bankruptcy:

➢ Liquidation

➢ Reorganization.

Liquidation means termination of the firm as a going concern; it involves selling the assets of the
firm for salvage value. The proceeds, net of transactions costs, are distributed to creditors in order
of established priority. Reorganization is the option of keeping the firm a going concern; it
sometimes involves issuing new securities to replace old securities.
Bankruptcy Liquidation Vs Reorganization

In a reorganization, the debtor retains ownership of its assets and continues business operations
while renegotiating debt repayments with creditors.

In a liquidation, the creditors seize control of the debtors assets and sell them to pay off the debt.
Furthermore, the debtor goes out of business and ceases normal operations. After liquidation, the
entity technically no longer exists.

Bankruptcy Liquidation & Reorganization

Application of procedures:

• Very small firms (i.e., with assets less than $100,000), are more likely to liquidate than
reorganize compared to large firms.

• Firms with a large number of secured creditors are more likely to try to reorganize.

• Firms with an unsecured creditor, especially a bank, are more likely to choose liquidation.

• Firms that have large negative equity are more likely to try to reorganize.

Bankruptcy Liquidation- Consequences

1. A petition is filed in a federal court. A corporation may file a voluntary petition, or involuntary
petitions may be filed against the corporation.

2. A bankruptcy trustee is elected by the creditors to take over the assets of the debtor corporation.
The trustee will attempt to liquidate the assets.

3. When the assets are liquidated, after payment of the costs of administration, proceeds are
distributed among the creditors.

4. If any assets remain after expenses and payments to creditors, they are distributed to the
shareholders.

Conditions Leading to Involuntary Bankruptcy

An involuntary bankruptcy petition may be filed by creditors if both the following conditions are
met:

1. The corporation is not paying debts as they become due.

2. The creditors are entitled to file a plaint to initiate bankruptcy proceeding, if they can prove
firstly, that they are eligible creditor, secondly, that the aggregate amount of debt amounts to Tk.
500,000.

3. The plaint is filed within one year from the date of commission of act of bankruptcy.

Priority of Claims

Once a corporation is determined to be bankrupt, liquidation takes place. The distribution of the
proceeds of the liquidation occurs according to the following priority:

1. Administration expenses associated with liquidating the bankrupt company’s assets.

2. Unsecured claims arising after the filing of an involuntary bankruptcy petition.

3. Wages, salaries, and commissions.

4. Contributions to employee benefit plans arising within 180 days before the filing date.
5. Consumer claims.
6. Tax claims.
7. Secured and unsecured creditors’ claims.
8. Preferred stockholders’ claims.
9. Common stockholders’ claims.

Bankruptcy Reorganization- Consequences

1. A voluntary petition can be filed by the corporation, or an involuntary petition can be filed. The
involuntary petition must allege that the corporation is not paying its debts.

2. Usually, a federal judge approves the petition, and a time for filing proofs of claims of creditors
and of shareholders is set.
3. In most cases, the corporation (the “debtor in possession”) continues to run the business. 4. For
120 days only the corporation can file a reorganization plan. If it does, the corporation is given 180 days
from the filing date to gain acceptance of the plan.

5. Creditors and shareholders are divided into classes. A class of creditors accepts the plan if two
thirds of the class (in dollar amount) and one-half of the class (in number) have indicated approval.

6. After acceptance by creditors, the plan is confirmed by the court.

7. Payments in cash, property, and securities are made to creditors and shareholders. The plan may
provide for the issuance of new securities.

Private Workout or Bankruptcy: Which Is Best?

A firm that defaults on its debt payments will need to restructure its financial claims. The firm will
have two choices: Formal bankruptcy or private workout.

Here we discuss about private workouts with bankruptcy reorganizations. Both types of financial
restructuring involve exchanging new financial claims for old financial claims. Usually, senior
debt is replaced with junior debt and junior debt is replaced with equity.

To search the answer we should discuss about the advantages and disadvantages of Formal
Bankruptcy reorganization versus Private workout.

Advantages of Bankruptcy Reorganizations Vs. Private Workout

➢ Formal bankruptcy reorganization allows firms to issue new debt that is senior to all
previously issued debt. This new senior debt can provide enough cash for the firm to
continue to conduct its business.

➢ An automatic stay provision protects the firm from its creditors during bankruptcy
proceedings.

➢ A private workout requires acceptance of the plan by all creditors, formal bankruptcy
requires acceptance of the plan by one-half of creditors owning 2/3 of outstanding claims.
Disadvantages of Bankruptcy Reorganizations Vs. Private Workout

➢ Legal and professional fees are high in case of bankruptcy.

➢ In bankruptcy reorganization judges are required to approve all major business decisions.
All stakeholders can be adversely affected if judges make financing and investment
decisions that are not based on maximizing firm value.

➢ Lost investment opportunities represent one form of opportunity costs in bankruptcy

proceedings.

Other facts
➢ Recently, formal bankruptcies have dominated over private workout.

➢ Firms that emerge from private workouts experience stock price increases than those for
firms emerging from formal bankruptcies.

➢ The direct costs of private workouts are much less than the costs of formal bankruptcies.

➢ Top management usually loses pay and sometimes jobs in both private workouts and
formal bankruptcies.

➢ These facts, when taken together, seem to suggest that a private workout is much better
than a formal bankruptcy.

Why do firms ever use formal bankruptcies to restructure?

The Marginal Firm

Formal bankruptcy allows firms to issue debt that is senior to all previously incurred debt. This
new debt is “debtor in possession” (DIP) debt. For firms that need a temporary injection of cash,
DIP debt makes bankruptcy reorganization an attractive alternative to a private workout. There are
some tax advantages to bankruptcy. Firms do not lose tax carry forwards in bankruptcy, and the
tax treatment of the cancellation of indebtedness is better in bankruptcy. Also, interest on pre
bankruptcy unsecured debt stops accruing in formal bankruptcy.
Holdouts
Bankruptcy is usually better for the equity investors than it is for the creditors.

➢ Using DIP debt and stopping pre-bankruptcy interest from accruing on unsecured debt
helps the stockholders and hurts the creditors.

➢ The absolute priority rule, which favors creditors over equity investors, is usually violated
in formal bankruptcy. The creditors are often forced to give up some of their seniority rights
to get management and the equity investors to agree to a deal.

Complexity

A firm with a complicated capital structure will have more trouble putting together
a private workout. Firms with secured creditors and trade creditors will usually use
formal bankruptcy because it is too hard to reach an agreement with many different
types of creditors.

Lack of Information
When a firm initially experiences a cash flow shortfall, it may not know whether the shortfall is
permanent or temporary. If the shortfall is permanent, creditors will push for a formal
reorganization or liquidation.

However, if the cash flow shortfall is temporary, formal reorganization or liquidation may not be

necessary. Equity investors will push for this viewpoint. This conflict of interest cannot easily be
resolved.

The Z-Score Model

The Altman Z Score model, defined as a financial model to predict the likelihood of bankruptcy in
a company, was created by Edward I. Altman. Altman was a professor at the Leonard N. Stern
School of Business of New York University. His aim at predicting bankruptcy began around the
time of the great depression, in response to a sharp rise in the incidence of default.
The Z-Score Model- Purposes
The purpose of the Z Score Model is to measure a company’s financial health and to predict the
probability that a company will collapse within 2 years. It is proven to be very accurate to
forecast bankruptcy in a wide variety of contexts and markets.

The general idea is to find factors that enable the lenders to discriminate between good and

bad credit risks. To put it more precisely, lenders want to identify attributes of the borrower that
can be used to predict default or bankruptcy.