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, let‘s 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 firm‘s 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 Assets22,000 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 Equity22,000

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 X’s Debt Ratio is an indicator of its good performance, we need to look at: • the historical trend of the ratio • A comparison of the company’s 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 shareholder’s 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 X’s 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 company’s 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 company‘s 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, company‘s 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 firm‘s 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%

39. 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 firm’s product prices to go up • Pushing price increases to consumers usually affects the company’s 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.