FINANCIAL DISTRESS AND BUSINESS FAILURE

Financial distress is a situation where a firm’s operating cash flows are insufficient
to cover its obligations i.e. cash inflows are insufficient to cover cash outflows.
Financial distress means that the firm is unable to meet its obligations as and when
they fall due.

Business failure on the other hand refers to any business that has terminated its
operations with a resultant loss to creditors.

TYPES OF FINANCIAL DISTRESS

There are a number of ways in which financial distress can be manifested. These
include
(i) Technical insolvency – A firm is technically insolvent if it cannot meet its
short term obligations as and when they fall due. It results from poor
working capital management resulting into temporary lack of liquidity. The
firm experiences negative net working capital i.e. Current liabilities >
Current assets.
(ii) Insolvency in Bankruptcy – A firm is said to be insolvent in bankruptcy
when its total liabilities are greater than the market value of the firms’
assets. The firm experiences negative net worth i.e. Total liabilities > Total
assets. This is a more serious problem than technical insolvency because it
results into business failure.
(iii) Legal bankruptcy – A firm becomes legally bankrupt when it files for
bankruptcy and is declared as such in the courts of law.
(iv) Business failure – Dun & Bradstreet (compilers of business failure
statistics) define business failure as any business that has terminated its
operations with a resultant loss to creditors.

NATURE OF FINANCIAL DISTRESS

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Financial distress spreads from relatively mild to severe financial distress. The
above types of financial distress lie along a continuum from mild to moderate to
severe financial distress

___________________________________________________
Mild Moderate Severe
Short term phenomena Long term
Technical insolvency moving towards overall insolvency
Working capital mgt problem winding up

e.g. slow stock turnover, debtors turnover and cash

value is negative.
Value of firm still positive

CAUSES OF FINANCIAL DISTRESS

(i) Too much leverage – A study done by Dun & Bradstreet concluded that
47.3% of the causes of financial distress are a result of financial factors
especially using too much financial leverage.

(ii) Economic factors such as industry weaknesses, poor location economic

cycles etc constitute 37.1%

(iii) A combination of neglect, disasters and fraud accounted for 14.0%

(iv) Other factors constitute 1.6% and include the following:

• Over trading – Emphasizing profitability at the expense of liquidity.

• Poor quality products or irrelevant products.
• Stiff competition and failure to respond to competition
• Failure to source inputs/scarce/costly inputs
• Poor information gathering/failure to respond to market information.
• Changes in legislation e.g. a government ban on the use of polyethylene
bags
• Poor management.

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MEASURES FOR ADDRESSING FINANCIAL DISTRESS
Depending on the nature of financial distress management can use the following
measures for addressing financial distress.

(i) Mild financial distress can be addressed by adjusting cash flows to meet the
firms’ obligations i.e. make adjustments in the way working capital is
managed. This can be through selling debtors to factor firms, reducing
inventories by selling them at special prices, reduce cash outflows by
cutting frills and perks to management and employee salaries, delaying
payments to trade creditors, reducing advertising expenditure etc.
(ii) If the financial distress is mild or severe the following approaches can be
used.
• Corporate restructuring – which involves changes in ownership, capital
structure and operations.
• Distress restructuring – which involves actions from outside the company
especially by creditors.

DISTRESS RESTRUCTURING
Distress restructuring can be through;
(i) Voluntary settlements
(ii) Involuntary settlements.

Voluntary Settlements – These include

(a) Extension schemes – This involves the firm convincing short term and long
term creditors to postpone the maturity of obligations hence giving
temporary relief.
(b) Composition schemes – Under these schemes, creditors accept partial
settlement of their dues as final settlement of their obligations. The
creditors therefore receive a dividend in the shillings e.g 70% of their dues.

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 (c) Subordination schemes – The firm negotiates with creditors to convince
them to accept claims of inferior quality to their existing claims (superior
claims). This involves converting debt holders into equity holders
(d) Voluntary liquidation – If it is obvious that the firm is more valuable dead
than alive, then informal procedures (done outside courts of law) can be
taken to liquidate the firm. It usually yields larger amounts than in formal
bankruptcy because it avoids legal and related costs.

Involuntary Settlements - This is largely through a forced sale or involuntary

winding up. This happens when creditors are not agreeable to voluntary schemes

Considerations in distress restructuring

• The schemes should be acceptable to all, creditors. If not, dissenting
creditors should be paid their claims i.e. their must be a plan for minorities.
• Reforecast cash flows.
• Restructuring of product lines.
• Restructuring of management.
• Value of the firm in distress restructuring must be greater than value in
liquidation.

Rationale for voluntary settlements

To management – Job security
To shareholders – Relief from financial problems
To creditors:- (i) Avoid being seen as ones who led to collapse of company
(ii) Value in liquidation is usually depressed.

CORPORATE RESTRUCTURING
This involves changes in ownership, capital structure and operations that are
outside the ordinary course of business.

Rationale for Corporate restructuring

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• Efficiency gains e.g. in a merger synergetic effect (2 + 2 = 5). Sources of synergy
include operating economies of scale, financial gains, market power and surplus
managerial talent. On the other hand, efficiency gains in a divestiture are a result of
reverse synergy (4-2 = 3).
• Strategic realignment.
• Information effect
• Tax benefits. Where corporate restructuring involves increased leverage there will
be a tax shield advantage.

Techniques for corporate restructuring

1. Expansion
- Mergers – Two or more companies of the same size combine to form one
company.
- Acquisitions – one company acquires controlling effort in another e.g over
assets/management. The two may remain independent.
- Takeovers – One company takes over another company and the bidder
company maintains its original name.

Rationale for these schemes

• Vab = Va + Vb + Synergy.
• Diversification of risk.
• Reduce competition.
• Vertical and horizontal integration.
• Economies of scale.
• Managers in search of power

2. Divestiture and re-arrangements

- Sell off part of the enterprise i.e. a division or subsidiary
- Equity curve outs – Common stock of the business unit is sold to public but
parent company continues to have an equity stake in the subsidiary.
- Liquidation

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3. Ownership restructuring
- Selling the Company
- Share repurchase
- Security exchange offers
- Going private
- Leveraged buyouts
- Management buyouts.
- Management buy-ins