Financial distress: Financial distress is a condition in which a company or individual cannot

generate revenue or income because it is unable to meet or cannot pay its financial obligations.
This generally due to high fixed costs, illiquid assets, or revenues sensitive to economic
downturns. Ignoring the signs of financial distress can be devastating for a company. There may
come a time when severe financial distress cannot be remedied because the c because the
company or individual’s obligations are too high and cannot be paid, and there is just not enough
revenue to offset the debt. If this happens, bankruptcy may be the only option.

Financial distress is a term in corporate finance used to indicate a condition when promises to
creditors of a company are broken or honored with difficulty. If financial distress cannot be
relieved, it can lead to bankruptcy. Financial distress is usually associated with some costs to the
company; these are known as costs of financial distress.

Causes of financial distress:

Endogenous causes:

*weak management and its mistakes,

* insufficient financial control,

* poor management of working capital, high expenses,

* insufficient marketing,

* undertaking projects which are too large for the company,

* excessive production volume compared to the structure of financing,

2. Exogenous causes:

* negative changes in market demand for the company’s products.

*competition,

*change in input commodity prices in an unfavorable direction.

Symptom of Financial distress:

There are a variety of warning signs that indicate that a company is experiencing financial
distress. Being aware of these signals can help prevent failure. Here are some of the top 10 signs
which could help you avoid financial distress.

a. Poor profits: However obvious, poor profits are usually the first indicator that a business is not
doing well. When a business struggles to break even, that is an indicator it will not sustain itself
from internal funds and will be forced to raise capital externally.
b. Poor sales growth or decline: Growth in sales is an indicator that the market is positively
receiving your chosen products or services based on your business model.

c. Poor quality of products and services: when the quality of your product starts to decline it is
more that likely your customers will start buying from your competitors.

d. Negative cash flow: Cash flow statements are a critical indicator of financial distress. A
negative cash flow statement implies that the company is paying more cash than it is generating
from its operations.

e. Slow paying customers: Debtors may take too long to settle their debts with the company. This
can severely stretch the cash flow and as a result, the company will not have enough cash on
time to pay its own creditors and liabilities.

f. Low current ratio: Current ratio is the ratio between current assets and current liabilities. Best
practice dictates that this ratio should always remain greater than one.

g. Declining relationship with the bank: When this relationship becomes significantly strained;
asking for extra security, personal guarantees, debentures, withdrawing overdrafts and of course
declined loans, it more often than not implies that the business creditworthiness has been
adversely eroded.

Bankruptcy: Bankruptcy is a legal process through which people or other entities who cannot
repay debts to creditors may seek relief from some or all of their debts. Bankruptcy is the legal
proceeding involving a person or business that is unable to repay outstanding debts.

Types of bankruptcy:

a. Chapter 7 Bankruptcy/Straight or liquation bankruptcy: Chapter 7 is also called straight

bankruptcy or liquidation bankruptcy. It’s the type most people think about when the word
“bankruptcy” comes to mine. The court appoints a trustee to oversee your case. Part of the
trustee’s job is to take your assets, sell them and distribute the money to the creditors who file
proper claims. The trustee doesn’t take all your property. You’re allowed to keep enough
“exempt” property to get a “fresh start.” There are eligibility requirements to file in Chapter 7,
such as the debtor must have had no Chapter 7 bankruptcy discharged in the preceding eight year
and the applicant must pass a mean test.

b. Chapter 11 Bankruptcy/ Business reorganization bankruptcy: During a reorganization

bankruptcy proceeding, the court will help a business restructure its debts and obligations. In
most cases, the firm remains open and operating. Reorganization bankruptcy is a better choice
for businesses that may have realistic chance to turn things around. Reorganization plan provide
for payments to creditors over some period of time which may exceed twenty years. It usually
takes over a year to confirm a plan.
c. Chapter 13 Bankruptcy/ Wage earner’s plan: Chapter 13 bankruptcy is also call the “wage
earner’s plan,” because those who file need regular income to qualify. Instead of having your
debt forgiven, you’ll restructure your debt with a three- to five-year repayment plan. As part of
the financial reorganization of chapter13, the debtor must submit and follow through with a plan
to repay outstanding creditors within three to five years. In most circumstances, the repayment
plan must provide a substantial payback to creditors- as least equal to what they would receive
under other forms of bankruptcy- and it must, if needed, use 100% of the debtor’s income for
repayment.

Chapter 7 vs. Chapter 13: In both a Chapter 13 and a Chapter 7 case the debtor ends up with a
discharge of debt- that is, the debtor is relieved from the obligation to pay certain debts. The
difference is in how a debtor gets to the discharge. In a Chapter 7 case, he is required to turn over
any nonexempt property. In a chapter 7 case, the debtor would turn over all nonexempt property
to a trustee, who will sell it for the benefit of the debtor’s creditors In Chapter 13 case, instead of
turning over property for a trustee to sell, the debtor makes payments for 36 to 60 months to a
Chapter 13 trustee who distributes the funds to creditors who have field claims that the court
agrees are proper.

Causes of Bankruptcy:

a. Bankruptcy might be triggered by the overall market condition in the region of operation. A
recession-hit economy will not only lead to an increase in competition but also impact
operational costs that might rise suddenly.

b. Poor financial management is also one of the major causes for a business going bankrupt.
Many times, due to inadequate savings and low revenue, business owners end up procuring
massive business loans in order to finance their day-to-day operations.

c. More often small and medium enterprise owners fail to keep an eye over their tax structure.

d. Lack of cash inflow is the most prevalent reasons for a company to a bankrupt. The current
supply and demand market has a huge influence on this factor.

e. Investing in Non-performing assets can actually put the company under bankruptcy.

f. The business decisions of the company should be visionary. Wrong business decisions without
a proper foresight is a reason that many companies go bankrupt.

g. If the company takes too many debts at the same time, repaying them properly requires a
special care.
Symptom of Bankruptcy:

The business signs:

* New orders slowing down: New business drops or stops entirely.

* Less work from regular customers: A sure sign the market is running down.

*Cost cutting for no stated reason: The is damage control, and its, an indicator of overheads
starting to make a serious impact.

* Upgrades of plant and equipment or office systems stops: If necessary upgrades aren’t
happening.

* customer going out of business: If a big customers crashes, they can take their suppliers with
them.

In the workplace:

*Stagnant work environment: Less work, and no apparent efforts to do much more than go
through the motions. This means nothing is happening in terms of the business. The is a
particularly bad sign.

*Total silence from management: In active business, management produces regular new
information. In a business going bankrupt, the preoccupation with the financial situation tends to
blot out all other issues. No new information is provided.

Altman Z Score:

The Z-score is a linear combination of four or five common business ratios, weighted by
coefficients. The Altman Z Score is used to predict the likelihood that a business will go
bankrupt within the next two years. The formula is based on information found in the income
statement and balance sheet of an organization; as such, it can be readily derived from
commonly-available information. Given the ease with which the required information can be
found, The Z score is a useful metric for an outsider who has access to a company’s financial
statements. In its original form, the Z score formula is as follows:

a. Original Z-score:

The original Z-score formula was as follows:

X1 =working capital/total assets. This measures liquid assets in relation to the size of the
company.

X2 = retained earnings/ total assets. This measures profitability that reflects the company’s age
and earning power.
X3= earnings before interest and taxes/total assets. This 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. This indicates the effects of a decline
in market value of a company’s shares.

b. Z-score estimated for private firms:

Z=0.717 X1+0847X2+3.107 X3+0.420 X4+0.998X5

Where,

X1=(Current assetscurrent liabilities)/total assets

X2 = retained earnings/ total assets

X3= earnings before interest and taxes/total assets

X4 = book value of equity/ total liabilities

X5= sales/total assets

Zones of discrimination:

Z>2.9 “Safe” Zone

1.23< Z>2.9 “Grey” Zone

Z<1.23 “Distress” Zone

c. Z-score estimated for non-manufacturers& emerging markets:

Z-Score bankruptcy model:

Z=6.56 X1+3.26X2+6.72X3+1.05X4

Z-Score bankruptcy model (emerging markets):

Z=3.25+6.56X1+3.26X1+6.72X3+1.05X4

Where,

X1 = (current assetscurrent liabilities)/total assets

X2 = retained earnings/ total assets

X3= earnings before interest and taxes/total assets

X4 = book value of equity/ total liabilities

Zones of discriminations:

Z>2.6 “Safe” Zone

1.1 <Z< 2.6 “Grey” Zone

Z <1.1 “Distress” Zone

Bankometer model:

S=1.5X1+1.2X2+3.53+0.6X4+0.3X5+0.4X6

Where:

X1= CA or Capital Asset Ratio

X2 = EA or equity to Asset

X3 = CAR or Capital Adequacy Ratio

X4= NPL or non-performing loans to Loans

X5=CI or Cost to Income

X6= LA or Loan to asset

Criteria:

a. For the value of S<50 means that the company is experiencing financial difficulties and high
risk.

b. For the value of 50<S<70 then the company is considered to be in the gray area (gray area).

c. For S greater than 70, provide an assessment that the company is in a very healthy state.