CH14 - Corporate Failure and Reconstruction Flashcards
Ratio Analysis
Profitability
* ROCE – NOPBT or NOPAT/Capital Employed – Current Liabilities or Equity + Long-term debt
* Asset turnover – Revenue/Capital Employed
* Operating Profit Margin
Liquidity Ratios
* Receivable Days – Receivables/Credit Sales365
* Payable Days – Payables/Purchases365
* Inventory Holding period – Inventory/CoS*365
* Cash Operating Cycles – Debtor Days + Inventory holding period – Creditor days
Gearing
* Balance sheet gearing – Debt/Equity or Debt/Debt+Equity (Equity Is share capital and reserves)
* SoPL gearing – Interest cover – PBIT/Finance charges
* Balance sheet – compare to other firms, SoPL gearing is easier as more up-to-date
Financial
- P/E Ratio = Share price/EPS
- Dividend Cover = EPS/DPS
- Dividend Yield = DPS/Share price
Ratio Analysis - Limitations
- Ratios are a snapshot – do not show whether these are improving or declining
- Need to compare to industry average ratio figures
- Good for short-term, but not long-term financial position
Warning Signs to Look Out for in Exam - Distress
- Net liability/current liability position is high
- Large contingent liabilities
- Important post-balance sheet events
- Worsening cash and cash equivalents position
- Necessary borrowing facilities not agreed
- Fixed-term debt approaching maturity without realistic expectation to renew or repay, or needing to use short-term finance to finance the long-term debt
- Refinancing required on debt repayments to continue operating
- Major debt restructuring
- Indications of withdrawal of support from creditors/debtors
- Negative Operating Cashflows
- Substantial operating losses or deterioration in the value of assets used to generate cash flows
- Adverse key financial ratios
- Arrears/Discontinuance of dividends
- Inability to Pay creditors
- Inability to meet debt repayments
- Change from credit terms to cash-on-delivery with suppliers
- Inability to obtain financing for new product development/investment into non-current assets
Operating Issues to look for
- Loss of key management/staff without replacement
- Loss of a major market, license, supplier
- Labour difficulties
- Market changes or technology which the company cannot adapt to, or which make key products obsolete
- Excessive dependence on a few product lines where the market is dying
Other Issues
- Non-compliance with regulatory requirements
- Pending legal or regulatory proceedings
- Changes in legislation or government policy that adversely affect the business
- New large competitors
- Bad Press
- Information in the chairman’s/directors’ report (changes to the board composition, warnings, evasions)
Methods of reconstruction for ailing businesses:
CVA – Company Voluntary Agreement
Writing off debt balances on the P&L against shareholders’ and creditors capital. Affects creditors’ rights. Designed to ensure that return to creditors is maximized.
Procedure
1. Application made to the court asking to call a meeting between company and creditors/debenture holders
2. Scheme of reconstruction in the meeting. If 75% in value for it will be sanctioned.
3. If court sanctions it, the scheme is binding on all creditors
Methods of reconstruction for ailing businesses:
Administration Order
Recovery plan, company and it’s directors applies for the order. It writes down debts and creditors and the bank are given equity in the business. New management are brough in to improve operational and financial management.
Corporate Reconstruction of a Solvent Company - Why?
- To reduce net of tax cost of borrowing
- To repay borrowing sooner or later
- To improve security of finance
- To make security in the company more attractive
- To improve the image to third parties
- To tidy up the SoFP
- Losses incurred and capital and long-term liabilities out of line with the current value of the firm
- New capital is required to regenerate the business
Types of Corporate Reconstruction
Debt to Equity, Equity to Debt, Debt from one from to Another, Equity from one form to Another
How to Answer a Question on ‘Likely position of key stakeholders upon Liquidation’ – Mini SoFP
Create a Mini SoFP
Revalued Assets +
Inventory +
Receivables +
Investment – Given in Q +
Total Assets Available +
Secured Debt (-) Paying off secured debt
Debentures (-) Paying off debt holders
Total Debt (-)
Other Payables (-)
Interest (-)
Trade Payables (-)
Available to Shareholders
Pay the preference shareholders first, then rest is left for ordinary shareholders
Creation of SoFP
Non-Current Assets
Revalued land
Revalued Building
Revalued Equipment
Total
Current Assets
Inventory
Receivables (written off if so)
Cash (Working – See Below)
Subtotal
Total Assets
Called Up Share Capital
Issued ordinary shares -W2 - Check Phone
Issued preference shares – W2 - Check Phone
Share premium – W2 - Check Phone
Capital reconstruction account (balancing figure)
Non-current liabilities: Debenture (Old + New)
Current liabilities: Trade payables
Total Equity and Liabilities
W1 - Cash Working
W1 – Cash
NEW share issue – ordinary shares
New debentures
Sale of investments
Subtotal
Less overdraft
Total
Calculation of Profit From above - Supporting working
Interest from above
Total
Tax
Total
Preference Dividend
Available for Equity
EPS – Above Div by Above table total Amount
Advising whether shareholders and debenture-holders should support the Reconstruction
Debenture Holders
Calculate Interest Cover – Expected Profits/Interest on Debt from SoFP – If above 2 – Good!
Mention comparing to prospective interest rate elsewhere.
Check if interest has been paid. Could apply to the courts for liquidation and based on prior workings would get full settlement. However, note that assets may not be worth as much as first thought.
Check the long-term e.g. are they being offered ordinary shares – will grow.
Higher and long-term interest rates given when they are paid? If they are not struggling for cash short-term then hold, if preference for short-term apply for liquidation.
Advising whether shareholders and debenture-holders should support the Reconstruction
Preference Shareholders
Compare amount of shares prior to after. Likely to have gained without contributing further capital.
Compare prior return compared to new return and also comment on any ordinary shares given.
Also the risk of liquidation – debt holders are paid first, but considering the prior workings pref should be ok.
Advising whether shareholders and debenture-holders should support the Reconstruction
Ordinary Shareholders
Calculate their holding and comment on retaining on stake. Check Voting rights before and after, assuming they take up their rights.
Shareholders won’t want to given that the company is failing, but if they cannot realise any further capital – liquidation and the shareholders get nothing.
Accepting the reconstruction means they still hold control and can benefit from future gains
Conversion of preference shares to debentures/loan notes – no real change to company and investors but
- Tax reasons – Preference shares are dividends, debentures aren’t. Therefore Preference shares aren’t an allowable charge in computing taxable profit
- Legal reasons - Reduces distributable profits by the nominal value of preference shares. Changes gearing
Conversion of Equity from one form to another
- Simplifying the capital structure, tidying up. Having only 1 or 2 classes of share capital. Carried out in accordance with the articles of association and approved by majority of share class affected.
- Makes shares more attractive to investors, subdivision to smaller units, conversion to stock.
- Eliminating reserves by issuing fully paid bonus shares. Tidying up. Removing share premium and capital redemption reserves. Recognizes that in inflationary times, most of the reserves can’t be paid out as dividends.
Conversion of debt from one form to another
Improves security, flexibility, cost of borrowing
- Security – Converting large creditors to long-term loans/debentures is much safer – hard to do,
- Flexibility – Hard to maneuver out of short-term debt. If already at borrowing limits – looking at leasing,
- Cost – secured loan finance on assets can be cheaper than unsecured. Can shift from relatively high cost to relatively cost,
Conversion of Equity to Debt
Payment to preference shareholders are dividends and therefore not an allowable charge in computing taxable profits - this would change
Legal Position - Reduction in capital. Company provisions relating to redemption of shares must be followed. Transfers from distributable profit to capital redemption reserve
MBOs - Management Buy Outs - How to and Notes
Look at all capital and liabilities: Equity, preference shares, Loan, Overdraft
Compare to agreed price to see how much will be left over for immediate use in trading.
Look at Gearing: Equity value compared to price paid minus equity value. It will be high - common for MBOs. Returns to equity are likely risky and high bankruptcy risk. BUT, comment on the fact the buyout team likely own % of a company for a small amount of qeuity.
If gearing high - difficult to raise extra finance, think assets as collateral, or covenents, interest etc
Calculate Cash commitments - First priority of the company
Loan repayments PV
Redeemable prefrence shares - cumulative - % of total paid per year. Can postpone but not avoid. Will need to repaid after years or alternative source of funds found
Overdraft
Working Capital - will need to finance working capital and fixed assets, if business is growing this is significant
Comment on profit growth or decline - revenue may be increasing, but are costs too? High investment may be required at the start in assets… Can they fund this? Will institutional investors sell if the past of the business isn’t great?
Institutional Involvement - Controlling stake? Able to determine aspects of the management, appointment of directors, strategic direction which may conflict with management. Also can control security of loan an interest payments. Will also likely demand a return on investment of say 5-7 years.
Weaknesses:
Type of business, Working Capital, Lack of assets, high debt?
Selling Off, DE bundling - Reasoning
Concentration of growth and maximisation of shareholder value:
Splitting off non-core activities may increase visibility of an under-valued asset
Businesses may perform better under new managerment
Sale of less profitable parts can be seen favourably by the market
May perform better when seperate
Reduction in complexity and managerial efficiency - Autonomy:
Smaller more felxibile and respond easily to change
Increased autonomy
Clearer strategic direction
Specialisation and focusing on what mgmt do best
Changes in the market may mean synergies no longer exist
Diversified businesses are harder to manage - requires more time management
Release of Financial resources for new investment:
Selling loss-making - releases cash
Reduces cost by downsizing and reducing complexity
Lump sum received
Selling Off, DE bundling - Spin-offs/demergers
Create a separate business(es) which perform better:
Shareholders own the same proiperotion of shares in new as old
Each company owns a share of assets in the new company
New management - new direction
Old company can sometimes be got rid of
Selling Off, DE bundling - Sell-offs
Sale of part of the business purely for cash:
For cash reasons
Prevent loss-making part of the business reducing value overall
Concentrate on core areas
Dispose of desirable part of the business to protect the rest of the business from takeover
Selling Off, DE bundling - Liquidation
Liquidation - entire business closed down, assets sold and proceeds liquidated to shareholders. When company is n longer viable
Selling Off, DE bundling - MBO Types
MBO
Leveraged buyout
Employee buyout
Mgmt buyin - mgrs outside the busienss
Spin-out
