FINANCIALLY TROUBLED BUSINESSES

 Financial Distress
 Occurs when a firm’s operating cash flows are insufficient to meet its current
and future contractual obligations
 Definition of financial distress in the Companies Act
 It appears unlikely that the company will be able to pay all its debts as
they fall due and payable within 6 months
 It appears likely that the company will become insolvent within the
immediately ensuing 6 months

Identify underperformance

This could be done by a preliminary analysis of the:

 Severity of the situation
The following tools can be used:
1. Financial Statement analysis (5-28 in your textbook)
Specifically Altman’s Failure prediction

The original Z-score formula devised by Altman was as follows:

Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5.

X1 = working capital / total assets. Measures liquid assets in relation

to the size of the company.
X2 = retained earnings / total assets. Measures profitability that
reflects the company's age and earning power.
X3 = earnings before interest and taxes / total assets. Measures
operating efficiency apart from tax and leveraging factors. It
recognizes operating earnings as being important to long-term
viability.
X4 = market value of equity / book value of total liabilities. Adds
market dimension that can show up security price fluctuation as a
possible red flag.
X5 = sales / total assets. Standard measure for total asset turnover
(varies greatly from industry to industry).

Altman found that the ratio profile for the bankrupt group fell at −0.25
avg, and for the non-bankrupt group at +4.48 avg.

The limitations of ratio analysis would apply to Altman and similar

models, but are overcome to some extent. Below is a discussion of this:

* Limited to analysis of monetary terms only - e.g. no recognition of

strength of management, favourable location etc.
* Historic cost concept distorts ratios when comparing inter-company.
* Different accounting policies may lead to differing results - e.g.
Weighted Average/FIFO; depreciation policies, research and
development, differing treatment of deferred tax, foreign currency
translation etc.
* 'Creative accounting' or 'window-dressing' can make financial
statements appear in a favourable light.
* Different companies in the same sector may have purchased their
assets at different times. A firm that has older, mostly depreciated plant
will often reflect much higher returns on assets than a comparable firm
that invested in newer plant only a few years ago.
* Corporate philosophy may mean that a firm has higher or lower ratios
without being more or less 'healthy' than a comparable firm
e.g. Corporate philosophy as regards long-term borrowings - some
firms prefer to utilise internally generated funds and not to borrow,
while other firms in the same business might be highly geared without
being any less financially sound.
• Altman's failure prediction model is a multivariate model, looking at
several ratios at once. As such, it overcomes the problem of window
dressing, as it is not usually possible to 'doctor' all the ratios.
• It is also important to monitor trends in the Altman ratio over time.

A similar model was devised by Dr J. H. de la Ray

Altman revised his for use in non-manufacturing companies and

emerging markets.
(Found to be successful in SA)

Z” = 6.56X1 + 3.26X2 + 6.72X3 + 1.05X4 X = Independent

X1 = (Current Assets – Current Liabilities)/Total assets
X 2= Retained earnings/ Total assets
X3= Earnings before Interest Taxes/Total assets
X4= Book values of Equity/Total liabilities

Discrimination zones
Z” > 2.6 “Safe” zone
1.1< Z” < 2. 6 “Grey” zone
Z” < 1.1 “Distress” zone

2. Kralicek’s Q –test

This one-dimensional grading test was created in the year 1991 by

the Austrian economist Peter Kralicek. It is mainly used in the
German speaking countries under the name Quick test, Q-test or
Kralicek´s Fast Test. This model is different as with the increasing
achieved value also the insolvency probability increases too.
 3. Credibility Index

A company’s credit rating can be used as a predictor.

Credit rating agencies such as Standard & Poor’s use ratios
extensively to analyse the credit quality of companies. Different
ratios are more relevant in different sectors. E.g. GP and inventory
turnover critical in the retail sector.
This rating has a major impact on the company’s ability to raise
debt and on the cost of such debt.
For further info see pg. 5-42 in your textbook.

 Cause of the problem

1. Unfavourable fluctuations in exchange rates

2. Increased competition on product lines
3. Higher fuel costs
4. Higher commodity/input prices
5. Higher freight costs
6. High interest rates – especially in a recession
7. Concentration risk – reliance on few customers
8. Overexpansion – High growth rate. (Lose control over quality, inadequate
planning and finance)
9. High staff turnover rate
10. Changes in government regulation
11. Exchange rate changes (weaker rand is a problem for importers – stronger
rand for exporters)
 12. Expansion into non-core business
13. Lax credit offering or collection
14. Failure to adapt to change (technology)

Smaller firms tend to be at greater risk of failure

Possible courses of action

 Merge with another firm in the sector

 Implement a rights issue
 Issue preference shares and convertible shares
 Suspend dividend payments
 Compromise with creditors and banks – reset loan covenants
 Sell non-core assets
 Implement liquidation / winding up of the company

Workouts
(Private – public don’t know)
• A workout is a private restructuring of claims with creditors
• See King III’s Practice Note on Business Rescue (King IV = principles)
• Direct costs from a private workout is less than that of the business rescue
• Main advantage of private workouts is that it mitigates significant indirect costs:
1. Avoiding the negative effect on a firm’s reputation
2. Avoiding the negative impact on potential customers
3. Avoiding uncertainty about warranties
4. Retention of key employees

• Disadvantages
1. Obtaining further credit becomes difficult
2. Loss of suppliers
 3. No moratorium on claims against Co.

Business Rescue

Chapter 6 of the Companies Act 2008 (Act 71 of 2008) provides for the efficient rescue and
recovery of financially distressed companies, in a manner that balances the rights and
interests of all relevant stakeholders.

All businesses that are financially distressed and want to take a decision to start rescue
proceedings can file a notice to start business rescue proceedings with the CIPC.

Business rescue can be initiated by:

 The board of directors;

 By an application to court when the business is financially distressed;
 Various affected persons by application to court (including shareholders, creditors,
registered trade unions and employees).

The decision by a board to pass a resolution for business rescue needs to be done urgently to
enable the business rescue practitioner to take control for the purposes of having a business
rescue plan approved and thereafter implemented.

A business rescue practitioner will be appointed to oversee and supervise on a temporary

basis the management, affairs and business of the company and to devise, prepare, develop
and implement a business rescue plan. The plan will be implemented if approved by
creditors and shareholders to the extent that the rights of the shareholders will be affected.

A director or a member would have a duty to pass consider passing a resolution for a
company’s business rescue or alternatively resolve to wind up or liquidate as soon as he or
she becomes knowingly aware that the company is either:

 financially distressed or
 is unable to pay its debts

During the company’s business rescue proceedings, each director of the company:

 would continue to exercise the functions of a director subject to the authority of the
practitioner duly appointed
 must assist the practitioner that is expected to operate the company and to continue to
run its business
 may delegate any power or function to the practitioner duly appointed that would
have full management control of the company in substitution for its board and pre-
existing management.

Important: No liquidation proceedings must have commenced against the company when a
decision is taken to start business rescue proceedings.

This is a public process, business rescue practitioners have to be paid. A limited period
moratorium is placed on creditor’s claims.
 The Process of Business Rescue

1. Resolution by shareholders / members for Business Rescue.

2. File notice of beginning of Business Rescue Proceedings with CIPC.
3. Publish the Notice to affected persons.
4. Company / CC appoints a Business Rescue Practitioner.
5. Management provides relevant facts to the Practitioner.
6. Company / CC files notice of appointment of Practitioner with CIPC and publishes
the notice.
7. Practitioner assumes control of Company / CC.
8. Practitioner investigates affairs of the Company / CC.
9. Meeting of Practitioner with employees and representatives.
10. Meeting of Practitioner with creditors to receive claims and confirm company / CC
can be rescued.
11. Seek a future for company / CC with management / owners / other experts.
12. Publish Business Rescue Plan for approval by creditors.
13. Creditors meeting and Shareholders (if applicable) meeting to consider Business
Rescue Plan.
14. Implement Business Rescue Plan.
15. If no vote to approve / revise Business Rescue Plan, notice of termination –
liquidation follows.

Is Business Rescue a Viable Option?

• Evidence from the USA’s similar version of business rescue indicates that business
rescues work for the larger firms – not for small firms
• Business rescue results in the temporary suspension and a moratorium on the rights of
creditors as well as the development and implementation of a plan to restructure its
affairs, property, debt and other liabilities in a way that maximizes the chances that
the Co. will continue to exist.

Liquidation

Liquidation is the process of bringing a business to an end and distributing its assets to
claimants. It is an event that usually occurs when a company is insolvent, meaning it cannot
pay its obligations when they are due. As company operations end, the remaining assets are
used to pay creditors and shareholders, based on the priority of their claims.

The liquidation may come about:

 as a result of a legal court process, or

 by a request of the creditors, or
 the company or close corporation may voluntary decide to be liquidated.

Legal personality is only terminated once the entity is “dissolved”.

Priority Rule in Liquidations

 • Distribution of proceeds from liquidating the company must be in the following order:
1. Administrative fees arising from liquidation
2. Wages and Salaries
3. Taxes owing
4. Secured & unsecured creditors
5. Preference shareholders
6. Ordinary shareholders

Some possible solutions to financial distress

Communication with bankers, key creditors, important customers and key employees that
Management has a credible plan.

 Prepare and implement a recovery business plan

 Prepare cash flow forecasts
 Reduce costs
 Change management – new CEO – strong Financial Director
 Sell non-core assets
 Dispose of poorly performing divisions
 Reduce inventory
 Defer or reduce capital expenditure
 Cut dividends
 Restructure loans and amend loan covenants
 Enter into sale and leaseback arrangements (Per use rental – reduces fixed costs)
 Introduce a proper system of internal cost controls
 Focus on core competencies
 New technology to reduce costs

Further info is available in Appendix 17.3 if you are interested in this topic.
LIQUIDATION VS BUSINESS RESCUE

EG 17.9