Analyze three factors that might be responsible for financial distress in a firm.
Factors responsible for financial distress:
|–||Poor Accounting/insufficient accounting practices
A company can struggle even if it hits its sales goals because of its financial practices.
Small business owners without accounting experience often make common mistakes
relating to incorrect pricing, debt service or cash flow statement.
– Unrealistic budgeting and pricing
Creating budgets based on unrealistic sales, revenue and expense projections can
lead to financial struggles a firm might not be able to overcome. It is just always easy
to reduce expenses when sales are low. Incorrect budget assumptions also lead to
improper pricing strategies.
|–||Cash flow problems
Cash flow is the pace at which money comes into and leaves the business, rather
than the amount of money that comes into and out of your business. Cash flow
problems can lead to financial distress.
– Poor debt management
Poor debt management can cause a variety of financial problems. This can expose a
firm to financial risk and hence financial distress.
– Low sales/high costs
Two of the most obvious reason business suffer financial distress are low sales and
high costs. When sales decrease, you must begin to drain your working cash and
increase your credit use. When you run out of cash and credit, you enter into a crisis
– Inability to meet financial obligations as and when they become due for
In this case, a firm may be exposed to both liquidity and financial risk which can
lead to financial distress and finally winding up.
In relation to corporate restructuring and re-organisation, distinguish between following
(i)Boot strapping” and “management buyout”
(ii) “Sell off” and “spin off”.
(i) Boot strapping and management buy-out:
Boot strapping buyouts are also known as leveraged buyouts. These are acquisitions
financed largely using debt finance.
Management buyouts are buyouts of an existing firm by existing managers running a
For management buyouts existing management will take over an existing firm. However,
in leveraged buyouts, the firm is sold to private investors.
(ii) Sell off and spin off:
Sell off is a form of divestment where a subsidiary firm is sold to a third party. There is
no creation of a new firm, the parent firm receives cash in the transaction.
Spin off involves splitting of an existing firm into one or more firms. The newly formed
firm operates autonomously without interference from the parent firm. This helps to
create value to existing shareholders
Evaluate four limitations of the Altman’s Z-score for predicting corporate failure.
Limitations of Altmans Z score model for predicting corporate failure
– Definition of what constitutes a failed firm is dubious. Altman uses firms whose
credit ratings are suspect.
– Variables in the model are of a counting nature, which assumes that they have
information containing stock returns that is conditional across varying stages of the
– The model also uses unadjusted accounting data that changes in market values of
non-current assets are not taken into account.
– Variables are selected for their productive performance not from their underlying
theory, also the variables exhibit considerable sample dependence.
– No cost functions for type I and type II errors. This would be useful to assess the
performance of the model.
a) Alternative ways of predicting corporate failure.
– Conditional probability model
Use of conditional probability models to replace discriminant analysis e.g. Logit
models – estimate probability of occurrence rather than simply fail or survive.
– The use of capital market data.
Lack of relevance, reliability, timeliness and consistency in accounting variables in
failure prediction models.
– Inflation accounting and failure prediction, inflation accounting should make ratiosmore economically relevant and thus financial distress prediction should improve.
– The use of non-financial indicators such as schwarts and menon (1985) showed that
failing firms have a greater tendency to switch auditors than successful firms.
– By using the Taffler’s model
Z = C0 + C1 return + C2 working capital + C3 financial risk + C4 liquidity combination
of variables = 53%, 13%, 18% and 16%.
– The Zeta credit risk model.
The Zeta model is merely an extension of the Z-score model which achieves better
|–||The KMV approach
Uses market – based quantitative techniques to assess credit risk.
Describe how managers of firms experiencing financial distress might jeopardise the
investments of bond holders with the “games” of asset substitution and under
Managers of financially distressed firms will have incentive to gamble with bondholders’
money. If little value will accrue to shareholders in the event of liquidation, management
while still in control of the distressed-company may invest in highly risky projects (asset
substitution) that have a small probability of a large payoff and a high probability of a
zero or low pay off. This may give shareholders a small probability of increasing their
wealth at the expense of bondholders. Shareholders also have little to no incentive to
invest more equity into a failing company.
Management may pass up good, positive net present value projects if their only source
of funding is new equity financing.
Explain the salient differences between Argenti’s model and Taffler’s model in their
utility in predicting corporate failure.
|Argentis’ model||Taffler’s model|
|This model is based on the calculation of
scores related to company defects,
management mistakes and symptoms of
failure. Company defects include; a
passive board, an autocratic Chief
Executive and weak budgeting control.
Managerial mistakes include high levels of
gearing, failure of a large project and
overtrading. Systems decline include
deteriorating ratios, quality and staff
moral and the use of “window dressing”
when preparing financial statements. This
model is based on past company data. Its
predictive ability, however, has not yet
|Taffler’s model is based on the following
series of ratios:
i) Sales/total assets
ii) The current ratio.
iii) The reciprocal of the current ratio.
iv) Earnings before tax/current liabilities.
There is yet insufficient evidence to
determine this model’s predictive qualities
In relation to financial distress, contrast between “stock based insolvency” and flow
Stock based insolvency occurs when the firm has a negative net worth, implying that
the realizable value of its assets is lower than its debt.
Flow based insolvency occurs when the operating cash flow of the firm is not enough to
meet its obligations.