Financial Management subject For undergraduate students (semester 4)

1. Financial difficulties and
bankruptcy
Meeting 9

2. • 1. Understanding financial difficulties and bankruptcy
• 2. Describe alternative financial difficulties
• 3. Be able to calculate bankruptcy prediction through univariate
analysis; calculate the ratio of fixed costs / operating income (BT / PO)
and Times Interest Earned (TIE). multivariate analysis; calculate Z
score).

3. Bankruptcy
• Bankruptcy represents the situation in which company is unable to
settle its liabilities (to banks, suppliers, employees, tax authorities,
etc) and therefore, according to law, company enters the bankruptcy
procedure.

4. Bankruptcy:

5. Financial distress
• 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.
• 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.

6. Financial distress:

7. Insolvency
• Definition of financial distress can be expanded somewhat by linking
it to insolvency.
• Insolvency is defined as:
Inability to pay one’s debts; lack of means of paying one’s debts. Such
a condition of assets and liabilities that the former made
immediately available would be insufficient to discharge the latter.

8. Insolvency:

9. Financial difficulties
Bankruptcy
We check Liabilities
In Balance Sheet
Financial distress
We check operating
CashFlow
In Cashflow Statement
Insolvency
We check Assets and
Liabilities
In Balance Sheet

10. Insolvency:
• Insolvency may lead to bankruptcy. Some of the largest U.S.
bankruptcies are represented in Table

11. General Motors (GM) case study
• In June 2008, General Motors (GM) reported second quarter net income of
negative $15 million.
• It also lost money in 2005 and 2007 and steadily lost its market share to
rivals such as Toyota, BMW, and Honda.
• Its accounting shareholder equity turned negative in 2006 and its stock
price decreased from $50 in late 2003 to about $1 in 2009.
• Automobile customers had good reason to worry about buying cars from
GM.
• GM struggled to increase sales, cut costs, attempted to sell, drew down
bank debt, and arranged for more long-term financing.
• GM was clearly a firm experiencing financial distress.

12. General Motors (GM) case study
• 1. Income ↓
• 2. Market share ↓
• 3. Shareholder equity ↓
• 4. Stock price ↓
• 5. Sales ↓
• 6. Debt ↑
• 7. Financial distress ↑

13. General Motors (GM) case study
• GM filed for bankruptcy on June 1, 2009.
• GM emerged from bankruptcy six weeks later and shares of GM were sold
in the world’s largest IPO (at the time) in November 2010.
• Most of the shares were owned by the U.S. Treasury in what had been one
of the biggest “bail outs” of a private firm by the U.S. Treasury.
• GM began paying cash dividends in 2014 and has five consecutive years of
positive cash flow.
• Of course, many firms experiencing financial distress and bankruptcy do
not fare as well as GM

14. General Motors (GM) case study
• 8. filling bankruptcy
• 9. selling shares to US Treasury
• 10. paying cash dividends
• 11. surviving

15. 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

17. Restructuring
• Some firms may actually benefit from financial distress by
restructuring their assets.
• For example, a recapitalization can change a firm’s behavior and force
a firm to dispose of unrelated businesses.
• A firm going through a levered recapitalization will add a great deal of
debt and, as a consequence, its cash flow may not be sufficient to
cover required payments, and it may be forced to sell its noncore
businesses.
• For some firms, financial distress may bring about new organizational
forms and new operating strategies.

18. Financial distress as indicator
• Financial distress can serve as a firm’s “early warning” system for
trouble. Firms with more debt will experience financial distress earlier
than firms with less debt.
• However, firms that experience financial distress earlier will have
more time for private workouts and reorganization. Firms with low
leverage will experience financial distress later and, in many
instances, be forced to liquidate.

19. Liquidation or reorganization
• Firms that cannot or choose not to make contractually required payments to creditors
have two basic options: Liquidation or 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.
•
Liquidation and formal reorganization may be done by bankruptcy.
• Bankruptcy is a
legal proceeding and can be done voluntarily with the corporation filing the petition or
involuntarily with the creditors filing the petition

20. Predicting Corporate Bankruptcy
• Many potential lenders use credit scoring models to assess the
creditworthiness of prospective borrowers.
• 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.

21. Univariate Analysis
• In univariate analysis, an attempt is made to predict distress on the basis of
single financial ratios.
• A path breaking attempt to predict corporate failure, employing univariate
analysis, was made by William H. Beaver in 1966 (University of Chicago)
• He defined failure as the inability of a firm to meet its financial obligations
as they mature. He compared the financial ratios of a sample of 79 firms
that failed with the financial ratios of a sample of 79 non-failed firms for
the same period of time—for each failed firm, a non-failed firm operating
in the same industry and of comparable size was selected.

22. Univariate Analysis
• For both the samples, Beaver examined a period of five years prior to
the point of failure for the failed firms and conducted three types of
analysis to determine the predictive power of financial ratios.
• His analysis suggested that many of the ratios employed by him
showed the power to signal a failure.
• The ratios of failed firms differed significantly from those of the non-
failed firms.
• Further, they worsened sharply during the five years prior to failure.

23. Times interest earned (TIE) or interest
coverage ratio

25. Times interest earned (TIE)
• The times interest earned ratio indicates the extent of which earnings
are available to meet interest payments.
• A lower times interest earned ratio means less earnings are available
to meet interest payments and that the business is more vulnerable
to increases in interest rates and being unable to meet their existing
outstanding loan obligations.

26. Times interest earned (TIE) or interest
coverage ratio
• Interest Charges = Traditionally "charges" refers to interest expense
found on the income statement.
• When the interest coverage ratio is smaller than 1, the company is
not generating enough cash from its operations EBIT to meet its
interest obligations.
• The Company would then have to either use cash on hand to make up
the difference or borrow funds.
• Typically, it is a warning sign when interest coverage falls below 2.5x.

27. Times interest earned (TIE) question
• For example, a business has net income of $100,000, income taxes of
$20,000, and interest expense of $40,000.
• Based on this information, its times interest earned ratio?

28. Times interest earned (TIE) answer
• Based on this information, its times interest earned ratio is 4:1, which
is calculated as:
• ($100,000 Net income + $20,000 Income taxes + $40,000 Interest
expense) ÷ $40,000 Interest expense
• A ratio of less than one indicates that a business may not be in a
position to pay its interest obligations, and so is more likely to default
on its debt.
• A much higher ratio is a strong indicator that the ability to service
debt is not a problem for a borrower.

29. There are a number of flaws associated with
this ratio, which are:
• The EBIT figure noted in the numerator of the formula is an accounting
calculation that does not necessarily relate to the amount of cash generated.
Thus, the ratio could be outstanding, but a business may not actually have any
cash with which to pay its interest charges. The reverse situation can also be true,
where the ratio is quite low, even though a borrower actually has significant
positive cash flows.
• The amount of interest expense appearing in the denominator of the formula is
an accounting calculation that may incorporate a discount or premium on the sale
of bonds, and so does not equate to the actual amount of interest expense that
must be paid. In these cases, it is better to use the interest rate stated on the face
of the bonds.
• The ratio does not take account of any looming principal paydown, which could
be large enough to bring about the bankruptcy of the borrower, or at least force it
to refinance at a higher rate of interest, and with more severe loan covenants
than it currently has.

30. Multivariate Analysis
• Univariate analysis examines financial ratios individually but does
not assess the joint predictive power of various combinations of
ratios.
• Multivariate analysis, on the other hand, seeks to predict industrial
distress using a methodology that considers the combined influence
of several variables (financial ratios)

31. Background to the Z-Score
• The Z-Score was developed in 1968 by Edward I. Altman, an Assistant
Professor of Finance at New York University, as a quantitative
balance-sheet method of determining a company’s financial health.
• A Z-score can be calculated for all non-financial companies and the
lower the score, the greater the risk of the company falling into
financial distress.

32. Background to the Z-Score
• The original research was based on data from publicly held
manufacturers (66 firms, half of which had filed for bankruptcy).
• Altman calculated 22 common financial ratios for all of them and then
used multiple discriminant analysis to choose a small number of
those ratios that could best distinguish between a bankrupt firm and
a healthy one.
• To test the model, Altman then calculated the Z Scores for new
groups of bankrupt and nonbankrupt but sick firms (i.e. with reported
deficits) in order to discover how well the Z Score model could
distinguish between sick firms and the terminally ill.

33. Z-Score
• The results indicated that, if the Altman Z-Score is close to or below 3, it is wise to
do some serious due diligence before considering investing.
• The Z-score results usually have the following of interpretation:
• Z Score below 2.99 -“Safe” Zones. The company is considered ‘Safe’ based on the
financial figures only.
• 1.8 ≤ Z ≤ 2.99 -“Grey” Zones. There is a good chance of the company going
bankrupt within the next 2 years of operations.
• Z below 1.80 -“Distress” Zones. The score indicates a high probability of distress
within this time period.
• The Z-score has subsequently been re-estimated based on other datasets for
private manufacturing companies, as well as non-manufacturing / service
companies.

34. Does the Altman Z-Score Work?
• In its initial test, the Altman Z-Score was found to be 72% accurate in
predicting bankruptcy two years prior to the event. In subsequent
tests over 31 years up until 1999, the model was found to be 80-90%
accurate in predicting bankruptcy one year prior to the event.
• In 2009, Morgan Stanley strategy analyst, Graham Secker, used the Z-
score to rank a basket of European companies. He found that the
companies with weaker balance sheets underperformed the market
more than two thirds of the time. Morgan Stanley also found that a
company with an Altman Z-score of less than 1 tended to
underperform the wider market by more than 4%.

35. Altman Z-Scores and the Financial Crisis
• In 2007, the credit ratings of specific asset-related securities had been rated higher than
they should have been.
• The Altman Z-score indicated that the companies' risks were increasing significantly and
may have been heading for bankruptcy.
• Altman calculated that the median Altman Z-score of companies in 2007 was 1.81. These
companies' credit ratings were equivalent to B. This indicated that 50% of the firms
should have been rated lower, and they were highly distressed and had a high probability
of becoming bankrupt.
• Altman's calculations led him to believe that a crisis would occur and there would be a
meltdown in the credit market. Altman believed the crisis would stem from corporate
defaults, but the meltdown began with mortgage-backed securities (MBS). However,
corporations soon defaulted in 2009 at the second-highest rate in history.

36. Z score for public companies:
• For public companies, the z-score is calculated as follows:
• 1.2*T1 + 1.4*T2 + 3.3*T3 + 0.6*T4 + 1.0*T5
• T1 = Working Capital / Total Assets. This measures liquid assets as firm in trouble will
usually experience shrinking liquidity.
• T2 = Retained Earnings / Total Assets. This indicates the cumulative profitability of the
firm, as shrinking profitability is a warning sign.
• T3 = Earnings Before Interest and Taxes / Total Assets. This ratio shows how productive a
company in generating earnings, relative to its size.
• T4 = Market Value of Equity / Book Value of Total Liabilities. This offers a quick test of
how far the company's assets can decline before the firm becomes technically insolvent
(i.e. its liabilities exceed its assets).
• T5 = Sales/ Total Assets. Asset turnover is a measure of how effectively the firm uses its
assets to generate sales.

37. Z score for private companies:
• The usefulness of the original Z score measure was limited by two of
the ratios.
• The first ratio is T4, the Market Value of Equity divided by Total
Liabilities.
• Obviously, if a firm is not publicly traded, its equity has no market
value. To deal with this, there is a revised Z score for private
companies:
• Z1 = 0.717*T1 + 0.847*T2 + 3.107*T3 + 0.420*T4A + 0.998*T5 (in this
case, T4 = Book Value of Equity / Total Liabilities).

38. Z-score for non-manufacturing businesses:
• The other ratio is Asset Turnover T5. This ratio varies significantly by
industry but, because of the original sample, the Z Score expects a
value that is common to manufacturing. To deal with this, there is a
more general revised
• Z2 = 6.56*T1 + 3.26*T2 + 6.72*T3 + 1.05*T4A

39. Watch Out for
• The Z Score is not intended to predict when a firm will actually file for
legal bankruptcy.
• It is instead a measure of how closely a firm resembles other firms
that have filed for bankruptcy, i.e. it tries to assess the likelihood of
economic bankruptcy.
• Despite these flaws, the original Z Score model is still the most widely
used measure of corporate financial distress.

40. Altman X1 = Working Capital / Total Assets
• Working Capital/Total Assets = (Current Assets – Current Liabilities)/Total Assets
• This is a simple ratio to understand.
• This ratio provides information about the short term financial position of the business based on the balance
sheet.
• The more working capital there is compared to the total assets, the better the liquidity situation.
• With working capital you still have to remember two points.
• Point #1: Negative working capital isn’t always bad
• Companies with high inventory turnover can have negative working capital. If you take a look at Wal-Mart
(WMT), it has leverage over their suppliers with favorable payment terms so their current liabilities can
outweigh their current assets.
• Other examples include telecom companies such as Verizon (VZ) and airlines like Southwest (LUV) and
Allegiant (ALGT).
• Point #2: High positive working capital isn’t always good
• Just because working capital is high, it doesn’t automatically mean that it is good.
• It can indicate the company has too much inventory or they are not investing their excess cash.

41. Altman X2 = Retained Earnings / Total Assets
• Retained earnings is the percentage of net earnings that isn’t paid out as dividends –
hence the word “retained”.
• The company will use it to operate the business. It can be reinvested or used to pay off
debt. Up to management.
• But when you combine it total assets, the purpose of the ratio is now to measure how
much the company relies on debt.
• Makes sense.
• If a company has little to no retained earnings, then it has to get money from somewhere
to continue with operations. Where does that money come from? Debt or dilution.
• The lower the ratio, the company is funding assets by borrowing instead of through
retained earnings.
• This ratio is also a cousin to the equity multiplier used in the DuPont Analysis
where Equity Multiplier = Total Assets/Shareholders Equity

42. Altman X3 = EBIT / Total Assets
• If you squint hard enough at EBIT/Total Assets, it will look familiar.
• It’s a variation of a common ratio that you see everywhere.
• Don’t see it? Neither did I.
• EBIT/Total Assets is a variation of ROA.
• Instead of net income, EBIT is used in the numerator.
• ROA = Net Income/Total Assets
• The definition is the same though.
• This ratio looks at the company’s ability to generate profits from its
assets before deducting interest and taxes.

43. Altman X4 = Market Value of Equity / Total
Liabilities
• Out of the 5 components, this is the most controversial.
• This ratio is supposed to show you how much of the company’s market value could decline before liabilities exceed assets.
• The weakness is the market value of equity, aka market cap or stock price x shares outstanding.
• The problem is that if the stock price is high, then this ratio goes up.
• Here are two examples
• Tesla (TSLA)
• Market Cap: 51.18B
• Total liabilities: 17.54B
• Market Value of Equity / Total Liabilities = 51.18/17.54 = 2.9
• Wix.co (WIX)
• Market Cap: 3.69B
• Total liabilities: 217.15M
• Market Value of Equity / Total Liabilities = 3.69/0.217 = 17
• Both companies have negative PE’s, but because of Wix.com’s stock price compared to Tesla, it has a higher ratio.

44. Altman X5 = Net Sales / Total Assets
• This ratio is just asset turnover.
• I use it all the time outside of the Altman Z score as well as it is a
great indicator of efficiency and business quality when comparing
against previous years.
• Quite simply, it is looking at the dollar of sales generated by the
company for every dollar of assets.
• The more money you can generate from assets, the better.
• If two people start with $1,000 in total assets, but person A generates
$1,000 while person B generates $2,000, the winner is a no-brainer.

45. Z score question
• Let’s assume Bill’s Boats’ (public) financial statements had the
following figures:
• Sales: $1M
• EBIT: $500,000
• Total Assets: $2M
• Book Value of Total Liabilities: $1M
• Retained Earnings: $1M
• Market Value of Equity: $3M
• Working Capital: $500,000

46. Z score answer
• Altman score would be calculated like this:
• Score = 1.2(.25) + 1.4(.5) + 3.3(.25) + 0.6(3) + 1.0(.5)
Score = (.3 + .7 + .825 + 1.8 + .5) = 4.125
• A = $500,000/ $2,000,000
• B = $1,000,000 / $2,000,000
• C = $500,000 / $2,000,000
• D = $3,000,000 / $1,000,000
• E = $1,000,000 / $2,000,000

47. Z score answer
• Bill’s Boats’ score is 4.125.
• This means that the company isn’t close to insolvency.
• Bill is doing well with a score well above the 3+ rating.
• This means that investors and creditors shouldn’t be too worried
about the company according to this metric.
• Instead, they should look to other indicators to get a full picture of
Bill’s business.

48. Analysis
• The ZScore is an important measure in determining the financial strength of a company since it
relies on several different metrics. Many investors use it to gauge the solvency of a company and
decide whether to buy or sell an investment. The lower Z score indicates that a firm is gradually
approaching insolvency or bankruptcy. Thus, firms with lower scores are higher risk investments.
• Keep in mind that this calculation doesn’t work for new companies because their earnings are too
low. The low earnings negatively affect most of the ratios used in the Altman score calculation.
Thus, new companies tend to always have a low Altman score.
• Additionally, the Z score formula doesn’t reflect cash flows. For example, a highly profitable
company with poor cash flow might not be able to pay its liabilities and as a result will have to
declare bankruptcy.
• It is an important point to note that Z scores are not calculated for the purpose of estimating
when a company will file bankruptcy, but rather it helps in measuring how close a company
resembles other companies that have become insolvent. The model is widely criticized over the
years as it utilizes unexplained accounting data. Despite these criticisms, Z-score is still the one of
the most widely used measures of a company’s financial health.

49. A Critique of Bankruptcy Prediction Models
• We do not have a well-defined theory of corporate failure to guide
empirical work.
• In the absence of such a theory, empirical research involves a great
deal of experimentation with different variables (Altman, for example,
examined 22 ratios), different models (univariate and multivariate),
and various statistical techniques (regression analysis, discriminant
analysis, and so on)

50. A Critique of Bankruptcy Prediction Models
• Empirical studies are statistically flawed because they are
retrospective in nature.
• Altman demonstrated that failed and nonfailed firms have different
ratios, not that ratios have predictive power.
• But the crucial problem is to make an implication in the reverse
direction, i.e., from ratios to failures.
• It must be demonstrated that samples of ratios' values can indicate
failure and non-failure.