Models For Predicting Corporate Financial Distress Essay - 2,341 words

FACTORS AFFECTING FINANCIAL HEALTH 3 Capital Structure and Capital Adequacy 3 Operating Cash Flows and Cost Structure 4 Asset Conversions Growing Broke 5 Asset Utilisation Efficiency/Turnover 5 Other Statistical Failure Prediction Models 10 Alternative Models - Artificial Neural Networks 12 A company trying to achieve its business plan faces problems similar to those faced by a driver embarking on a long trip. The likelihood that car and driver will reach their destination is dependent on: 1) how much fuel is in the car's tank upon starting out, 3) how many service stations will be available to refill the car's fuel tank along the way and 4) whether the car's fuel tank is large enough to cover unexpected accidents, delays, and detours along the way. Similarly, whether or not a company survives in a highly competitive business environment is dependent upon: 1) how financially healthy the corporation is at its inception, 2) the company's ability (and relative flexibility and efficiency) in creating cash from its continuing operations, 3) the company's access to capital markets, and 4) the company's financial capacity and staying power when faced with unplanned cash shortfalls. There is no single measure of financial health. Ideally, solvency could be measured along a continuum in the same way that fuel sufficiency can be measured using a car's petrol gauge. Full health would equate with having a full tank of fuel.


Poor health would be equivalent to showing an empty tank. As healthiness progressively decreased, the solvency gauge would register movement in the direction of relative insolvency. Ultimately, as healthiness continues to decline, the solvency gauge would hopefully flash a warning light. Since, in the real world, no single measure of financial health exists, proxies that measure various aspects of solvency are often combined to estimate a company's healthiness at a point in time. As a financially healthy company becomes more and more financially distressed, it ultimately enters an area of great danger. Changes to the company's operations and capital structure (ie.


restructuring) must be made to remain healthy. Apple Computers' attempts in recent years to restructure its operations to survive in the highly competitive computer hardware business is a good example of a company trying to dramatically restructure itself in order to maintain solvency. Continued decreases in financial health ultimately lead to insolvency and then potentially, bankruptcy. Available evidence suggests many companies do not adequately attempt to resolve their financial health problems until it is too late to avoid bankruptcy. Capital Structure and Capital Adequacy Companies finance their long-term operations primarily through two sources of capital - debt and equity. One of the most important financing decisions a company makes is the proportion of debt to owner's equity in the company's capital structure.


Summary measures of a company's capital structure include the company's debt to equity ratio (D/E) and debt to total capital ratio (D/ (D+E) ). Interest and principal payments on debt must be paid from operations before any payments can be distributed to equity holders (in the form of dividends or share buy-backs). Therefore, the interest and principal, which must be paid on debt, are considered fixed-costs of operations. From an operational point-of-view, the extent of the burden of these fixed obligations can be measured relative to the company's continuing ability to pay the fixed obligations.


A frequently used measure of a company's ability to cover its interest payments is its earnings before interest and taxes and before depreciation and amortisation (EBITDA) to its interest expense. A company is financially distressed whenever its EBITDA is less than its interest expense. &# 61623; Financial leverage involves the substitution of fixed-cost debt for owner's equity in the hope of increasing equity returns. As demonstrated by Higgins and others, financial leverage improves financial performance when things are going well but worsens financial performance when things are going poorly. Therefore, increasing the ratio of debt to equity in a company's capital structure implicitly makes the company relatively less solvent (on the downside) and more financially risky than a company without debt. &# 61623; Capital adequacy relates to whether a company has enough capital to finance its planned future operations. If the company's capital is inadequate, then it must either be able to: 1) successfully issue new equity, or The amount of debt a company can successfully absorb and repay from its continuing operations is normally referred to as the company's debt capacity. Capital adequacy is normally evaluated by looking at the company's operational cash flow projections and its projections of capital needs.


When companies undertake major new projects or undergo a significant financial restructuring they often perform financial feasibility studies to determine whether the company has the financial capacity to undertake the project and whether the company will be able to repay all future debt payments once the project is built. Operating Cash Flows and Cost Structure All other factors being equal, companies that can consistently generate positive cash flows from operations will remain relatively more solvent than those that cannot. This requires that operating cash inflows (collections or sales) consistently exceed operating cash outflows (costs). Companies which experience erratic cash outflows and inflows are relatively more risky because they are less likely, in one or more time periods, to be able to cover fixed expenses / outflows . Companies which have a higher proportion of fixed costs to variable costs are also relatively more risky and relatively less solvent than companies with a relatively lower proportion of fixed costs in their operating cost structure. All other things being equal, companies with higher relative earnings and higher relative returns on investment will remain more solvent than their less fortunate competitors.


The most commonly used financial measures of earnings capacity are earnings before interest and taxes (EBIT) and net income. Adequate liquidity is a further necessary component of solvency. Frequently used liquidity measures include: a) working capital (current assets minus current liabilities), b) current ratio (current assets divided by current liabilities), and c) quick ratio (cash, marketable securities and accounts receivable divided by current liabilities). To evaluate liquidity, each of the assets and liabilities on a company's balance sheet should be evaluated for liquidity. Current assets are those which will likely be converted to cash within one year or less.


Current liabilities are those which must be paid within one year. However, when a company becomes financially distressed, even assets which are normally considered current assets (accounts receivable and stock, for example) may become relatively illiquid. Long-term assets, in general, are far less liquid than current assets. Some longer-term assets may be very illiquid. Also, as stated above, often a company's long-term liabilities can become immediately due and payable if the company violates contractual debt covenants or other obligations. Wilcox (1976) argues that "net liquidation value" provides a solid conceptual basis for evaluating a company's liquidity.


Net liquidation value is defined as total asset liquidation value less total liabilities. Wilcox (1976) applies what he calls typical (not definitive) valuation multipliers to balance sheet assets to arrive at representative asset liquidation values: Wilcox (1976) shows that a ...................................................................................................................................................................................................................................................................................................................................................................

...................You are reading a preview................... Visit our Blog and Unlock Full Access to this essay

Continue READING the FULL Essay by clicking HERE

Essay Tags: cash flows, accounts receivable, continuing operations, fuel tank, capital structure

This is an Essay sample / Research paper, you can use it for your research of: Models For Predicting Corporate Financial Distress