10 Financial Distresses (chapter 16)

Contents
Financial Distresses (chapter 16).................................................................1

10

10.1 Bankruptcy Costs...................................................................................... 1

10.2 Business Failure......................................................................................... 1
10.3 Some technical terms associate with bankruptcy.....................................2
10.4 Actions in Financial Distress......................................................................3

10.1

Bankruptcy Costs

If a company relies too much on debt to finance their activities, they may face higher
bankruptcy costs. Company with high bankruptcy costs will face direct costs and financial
distress scenario.
Direct costs
-

Legal and administrative costs

Ultimately cause bondholders to incur additional losses
Disincentive to debt financing

Financial distress
-

Significant problems in meeting debt obligations

Firms that experience financial distress do not necessarily file for bankruptcy
Larger than direct costs, but more difficult to measure and estimate
Stockholders want to avoid a formal bankruptcy filing
Bondholders want to keep existing assets intact so they can at least receive that money
Assets lose value as management spends time worrying about avoiding bankruptcy
instead of running the business
The firm may also lose sales, experience interrupted operations and lose valuable
employees

10.2

Business Failure

Sometimes, business may fail not due to too much debt alone, but also combination of several
reasons such as:-

Obsolete product
Companies will suffer drastic reduction in sales if the product they offer already
outdated. Their competitors may take over their market shares by offering current
state-of the art products incorporating the latest technology.

Lack of Diversification
Some companies offer single-line products and fail to diversify into multiple-line
product. As a result, if sales in a particular product are affected, it will be
compensated by revenues generated by others products.

Inefficient Management
The management team of a company is very important to the success of a firm. If
there mismanagement or inefficient management, then control over cost and expenses
will slacken, causing enormous

Company Gearing Policy

There are also companies which employ very high debt financing in their capital
structure. This exposes the company to high financial risk such that, if sales were to
decrease slightly, it may not have enough liquidity to pay interest on debt.

Expansion Policy
Too rapid an extension policy followed by a firm will lead to drying up of capital
funds. Companies may then suffer from insufficient working capital to carry on with
such project, leading to project abandonment.

10.3

Some technical terms associated with bankruptcy

Business failure business has terminated with a loss to creditors

Legal bankruptcy petition federal court for bankruptcy
Technical insolvency firm is unable to meet debt obligations
Accounting insolvency book value of equity is negative

Liquidation

Trustee takes over assets, sells them and distributes the proceeds according to the absolute
priority rule

Reorganization

Restructure the corporation with a provision to repay creditors

10.4

Actions in Financial Distress

There are five actions that can be taken, depend on how critical the financial conditions face
by the companys concern which some may just only need to be settle by negotiation and
some can only settle by liquidate the company :-

Liquidation
: - Represent the process of terminating the company as a going concern that begins by filing
a petition in court initiated voluntarily by the company or creditors. Other times, the cash
flows imbalance are too difficult to resolved or liabilities exceed the market value of all
assets, a firms business is terminated, all its assets are sold and the proceeds are used to pay
creditors, and any leftover proceeds are distributed.

Reorganization
-

: - it is a scheme of arrangements that a firm with financial distress may file for
reorganization to seek protection from its lenders. It provides the opportunity for the
firm to create a plan to restructure the debt, reorganize the business, and restore its
financial health before the proceeding land in court.

Scheme of arrangement will help the financial distress company to:: - to restrain creditors from taking any legal actions towards the company
: - To provide breathing time to improve the companys condition.

Bankrupt
: - a firm is bankrupt when it has filed a petition for a relief from its lenders, or it has
consented to a filing by its lenders. The filing implies that the firm is unable to meet the
financial obligations and unable to do so in the near future.

Default
: - a firm is in default if it violates one of the terms of a loan agreement or a bond indenture.
Normally, defaults can be either technical defaults or payment defaults. Technical default
occurs when a firm violates a loan covenant, and rarely leads to bankruptcy as negotiation
with lenders can mediate the problems

Insolvent
Types of Insolvency. There are two types of insolvency; stock based and flow based.
-

Stock based insolvency: - Firms net worth is negative. Total debt is higher than total
assets value. This will lead to liquidation

Flow based insolvency: - Firms Cash Flow is not enough to cover its current
obligations, that is, the firm cannot pay current obligation when they come due.
Usually it will lead to restructuring.