Financial Distress models

Beaver model
Blum Marc’s failing company
model
Wilcox model
Altman’s Z score model
L.C. Gupta model
 William H. Beaver`s Model
• He was the pioneer of corporate failure prediction models. He used financial ratios for
prediction of failure of firm.
• Univariate model studies Beaver (1966) compared patterns of 30 ratios in the 5 years
preceding bankruptcy.
• The purpose was to see which ratios could forecast bankruptcy and how many years in
advance the forecast could be made

“ Failure as the inability of a firm to pay it's Financial obligations as they mature.”

Characteristics of Failed Firms

• Bankruptcies,
• bond defaults,
• overdrawn bank accounts, and
• firms that omitted payment of preferred stock dividends
Method

• He selected a sample of 79 firms representing 38 different industries that had

failed during 1954 to 1964. He also took a matched sample of 79 non-failed
firms.

• He took this matched sample because the paired-sample design in conjunction

with the paired analysis is one way of compensating for the effects of industry
and asset size. (Whenever ratios are directly compared, the comparison
involves two firms from the same industry and asset-size class.)

• As previously indicated, each failed firm has a non failed "match" in the
sample.
• In the paired analysis, the ratios of the non failed firms are subtracted
from the ratios of the failed firms; the analysis is then based upon
the differences in the ratios rather than upon the ratios
themselves.
• Since every difference in the ratios always involves a comparison of
two firms (one failed and one non failed) from the same industry and
asset-size class, the potentially disruptive effects of industry and asset
size are mitigated.
Criteria
• Beaver used three criteria to select 30 ratios from the set of all possible combinations
of financial statement items. The criteria are:
• The first criterion was popularity-frequent appearance in the literature.
• The second criterion was that the ratios performed well in one of the previous
studies.
• The third criterion was that the ratio be defined in terms of a "cash-flow" concept.
The cash-flow ratios offer much promise for providing ratio analysis with a unified
framework.
• He tries to explain ratio analysis by means of the cash flow concept. He views the firm
as a reservoir of liquid assets. The reservoir is supplied by the cash-inflows and it is
drained by the cash outflows. The chance of insolvency is defined by the chance that
this reservoir is exhausted. The firm will then be unable to pay its obligations as they
come due i.e. failure.
 Analysis of Financial Ratios

• Profile Analysis
• Dichotomous Classification Test
• Non-failed > failed is a prediction that the mean value of the non-failed
firms will be greater than that of the failed firms.
• Debt is defined as current plus long-term liabilities plus preferred stock.
• Cash flow/total debt proved to be the best predictor overall.
• In the year prior to bankruptcy this model had a 13% misclassification
rate.
• There was a greater frequency of Type I errors relative to Type II
errors. The difficulty increased dramatically with the time horizon.
• Note: Type 1 error(false positive)
• Type 2 error(false negative)
 Ceteris Paribus Prepositions
• (1) The larger the reservoir, the smaller the probability of failure.
• (2) The larger the net liquid-asset flow from operations (i.e., cash
flow), the smaller the probability of failure.
• (3) The larger the amount of debt held, the greater the probability of
failure.
• (4) The larger the fund expenditures for operations, the greater the
probability of failure.
Merit and Demerits
• It was very simple , reviewing one ratio at a time.
• However Beaver does not derive an optimal set of ratios but tries only to explain the behavioral
pattern of chosen ratios in the situations of failure and non failure.
• Beaver’s ratios can be classified into 4 conventional ratio categories: liquidity, leverage, activity
and profitability ratios.
• In the profile analysis i.e. comparison of mean values of various parameters for failed and non-
failed firms he explained that :

• 1 .Failed firms not only have lower cash flow than non failed firms,
• 2. They also have a smaller reservoir of liquid assets.
• 3. the failed firms have less capacity to meet obligations,
• 4. they tend to incur more debt than do the non failed firms.
 Marc’s Blum Failing Company Model
The Failing Company Model (FCM) was developed by Marc Blum to assess the probability of
business failure.

The operational definition of failure used in this study was an

• in ability to pay debts as they become due,

• entrance into the bankruptcy or

• explicit agreement with creditors to reduce debts.

He treated the business firm as reservoir of financial resources and described its probability of
failure in terms of expected flow of these resources.

Analysis was applied to a paired sample of 115 failed and 115 non-failed firms to evaluate the
predictive accuracy of the model.

Sampling was based on four criteria utilized in following order – industry, sales, employees,
• According to this cash flow framework, other things being equal, the probability of failure is more likely:

• The smaller the reservoir

• The smaller the inflow of resources from operations in both the short

run and long run

• Larger the claims on resources by creditors

• Greater the outflow of resources required by operations of business

• ‘failure prone’ the industry location of the firm’s business

The FCM Model Prediction result:

• The model predicted the corporate failure with an accuracy of approximately

94%, when failure occurred with in one year from the date of prediction.

• Accuracy of 80% for failure two years into the future.

• Accuracy of 70% for failure three, four and five years distant.
WILCOX MODEL:(1971)
• Under this approach, bankruptcy is probable when a company's net liquidation value
(NLV) becomes negative. Net liquidation value is defined as total asset liquidation value
less total liabilities.
• From one period to the next, a company's NLV is increased by cash inflows and
decreased by cash outflows.
• Wilcox combined the cash inflows and outflows and defined them as "adjusted cash
flow."
• All other things being equal, the probability of a company's failure increases:
1. the smaller the company's beginning NLV, the smaller the company's adjusted (net)
cash flow
2. Wilcox uses the gambler's ruin formula (Feller, 1968) to show that a company's risk of
failure is dependent on;
the above factors plus,
the size of the company's adjusted cash flow "at risk" each period
• Wilcox views the exhaustion of liquidity re- serves that precedes
bankruptcy as the behavioral basis for firm failure.
• If a firm may drain its liquidity for a number of consecutive years but
If it stops drawing on its liquidity before depleting all its liquid
reserves, the firm may remain solvent; otherwise, failure ensues.
• Wilcox treats these drainage years as random events. This assump-
tion allows him to formulate the failure process statistically using a
gambler's ruin model.
Generally, the model is expressed as follows:
Pr (failure) = if X < 0
(1-X/1+X)ᶺN if X > 0
where
N = adjusted cash position/a,
X = mean adjusted cash flow/a, and
a = [(mean adjusted cash flow)2 + variance of adjusted cash flow]

Adjusted cash position =

cash +0.7 times current assets other than cash + 0.5 times long-term assets -liabilities.
Adjusted cash flow =
net income - dividends - 0.3 times the period-to- period increase in noncash current assets
- 0.5 times the period-to-period increase in long- term assets + stock issued in a merger or
acquisition.
• Model used companies' X values, as indications of shifts in liquidity
status, for discriminating between recovery and distress.
• Thus an X greater than zero indicated health, while one less than zero
indicated distress. Model assigned firms to a distress group (H,D) if their
X values fell below. The distress group (H,D) thus comprised firms that
had lost significant liquidity flow and were entering the ruin process.
• Model assigned firms to a recovery group (D,H) if their X values rose
above zero over the year t - 1 to t.
• Essentially, firms cross the X = 0 threshold well before the N = 0
threshold.
• The Wilcox model does not provide a cutoff score for predicting
failure.
• But further analysis of the Wilcox model allows us to identify firms
that are entering or leaving a state of significant distress.
Edward I. Altman`s Model

Improvement over Beaver`s univariate study.

Z-Score
Altman’s Z Score Model

The Z score, developed by Professor Edward I. Altman in 1968 gauges the likelihood of
bankruptcy in a publically traded manufacturing cos.
The Z score consists of 5 variables: Profitability, leverage, liquidity,solvency and activity.

Z = 1.2*X1 + 1.4*X2 + 3.3*X3 + 0.6*X4 + 1.0*X5

Z = 3.3*X1(EBIT/Total assets) + 1.2*X2(Net working capital/Total assets) +

1.0*X3(Sales/Total assets) + 0.6*X4(Market value of equity/Book value of debt) +
1.4*X5(Accumulated retained earnings/Total assets)
• X1 = Working Capital / Total Assets
Working capital = Current Assets – Current Liabilities
Total Assets = Current Assets + Non-Current Assets
• X1 = Working Capital / Total Assets
Working capital = Current Assets – Current Liabilities
Total Assets = Current Assets + Non-Current Assets
• X1 is a measure of the net liquid assets of the firm relative to the total
assets.
 X2 = Retained Earnings / Total Assets

Retained Earnings : The part of net earnings not paid out as dividends, but retained by the company
to be reinvested in its core business, or to pay debt.
Retained Earnings (RE) = Beginning RE + Net Income – Dividends
 This is a measure of cumulative profitability.
 The age of a firm is implicitly considered in this ratio.
 X2 = Retained Earnings / Total Assets

Retained Earnings : The part of net earnings not paid out as dividends, but retained by the company
to be reinvested in its core business, or to pay debt.
Retained Earnings (RE) = Beginning RE + Net Income – Dividends
 This is a measure of cumulative profitability.
 The age of a firm is implicitly considered in this ratio.
 For example, a relatively young firm will probably show a low RE/TA ratio because it has not had
time to build up its cumulative profits. Therefore, it may be argued that the young firm is
somewhat discriminated against in this analysis, and its chance of being classified as bankrupt is
relatively higher than another, older firm.
 But, this is precisely the situation in the real world. The incidence of failure is much higher in a
firm's earlier years.
X3 = EBIT / Total Assets

 X3 is a measure of firm's productivity which is crucial for the long-term survival of the company.
 It is a measure of productivity of an asset employed in an enterprise. The ultimate existence of
an enterprise is based on earning power.
X3 = EBIT / Total Assets

 X3 is a measure of firm's productivity which is crucial for the long-term survival of the company.
 It is a measure of productivity of an asset employed in an enterprise. The ultimate existence of
an enterprise is based on earning power.
 It measures how effectively a firm is using its resources.
 It measures the management's overall effectiveness as shown by the returns generated on sales
and investment.
X4 = Market Value of Equity / Total Debt
 X4 defines how the market views the company.
 The assumption is that with information being transmitted to the market on a constant basis, the
market is able to determine the worth of the company. This is then compared to firm's debt.
 It is reciprocal of familiar debt equity ratio. Equity is measured by the combined market value of all
shares, while debt includes both current and long term liabilities.
 This measure shows how much of an asset can decline in values before liabilities exceed the assets and
the concerns become insolvent.
 It measures the extent to which the firm has been financed by debt.
 Creditors look to the equity to provide the margin of safety, but by raising fund through debt, owners
gain the benefit of marinating control of the firm with limited investment.
X5 = Net Sales / Total Assets

 Net Sales is the amount of sales generated by a company after the deduction of returns, allowances for
damaged or missing goods and any discounts allowed.
 X5 is a 'measure of management ability to compete'.
 The total assets turnover ratio is a standard financial ratio illustrating the sales generating ability of the
firm's assets.
 It is one measure of management's capability in dealing with competitive conditions.
• Bankruptcy would be predicted if Z ≤ 1.81 and non-bankruptcy if
Z ≥ 2.99.
• scores between 1.81 and 2.99 should be thought of as a grey area.
• A score of Z less than 2.99 indicates that a firm has a 95 per cent
chance of becoming bankrupt within one year.
• Altman used a revised model to make it applicable for private firms and
non-manufacturers.

• The resulting model is:

Z = 6.56(Net working capital/Total assets) + 3.26(Accumulated retained

earnings/Total assets)+ 1.05(EBIT/Total assets) + 6.72(Book value of
equity/Total liabilities)

where Z  1.23 indicates a bankruptcy prediction.

1.23  Z  2.90 indicates a grey area,

and Z  2.90 indicates no bankruptcy

• Z < 1.23 indicates a bankruptcy prediction.
• 1.23 ≥ Z ≤ 2.90 indicates a grey area.
• Z > 2.90 indicates no bankruptcy.
Computation of average Z score Auto-Data.xls

Year/Z Score Maruti Suzuki Tata Motors M & M Ltd Ashok Leyland Average

2005 5.18 4.09 2.78 3.87 3.98

2006 7.72 6.13 5.14 5.48 6.12

2007 8.31 5.41 4.95 4.67 5.84

2008 11.74 6.69 7.27 5.92 7.91

2009 8.04 5.97 5.99 6.3 6.58

2010 7.72 4.29 5.68 5.38 5.77

2011 7.25 2.04 3.74 2.76 3.95

2012 9.9 2.71 4.17 3.46 5.06

2013 9.7 3.78 4.49 3.76 5.43

2014 7.27 3.98 4.76 3.65 4.92

Average 8.28 4.51 4.9 4.53 5.55

Comparison of average Z score

14

12

10

0
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Average

Maruti Suzuki Tata Motors M & M Ltd

Ashok Leyland Average
L.C Gupta’s Study (1979)

• Origin – American studies on bankruptcy were not relevant to the nature of the problem of
corporate sickness in India. This study is done with Indian data, attempted to distinguish sick
and non-sick companies on the basis of financial ratios.
• Concept - Survival strength of companies was derived from the concept of ‘marginal firm’.
Method
Companies Selected :
1. 41 cotton textile companies (20 sick and 21 non-sick)
2. 39 non-textile companies (18 sick and 21 non-sick)
• Period of Study : 13 years i.e.- 1962-74
• Number of ratios : 63
Classification of ratios :
Profitability ratios and Balance Sheet ratios
• Four major ratios :
1. EBDIT / Sales
2. Operating Cash Flow / Sales
3. EBDIT / Total Assets
4. EBDIT / (Interest + 0.25*Debt)
• The test was based on taking sample of sick and non-sick companies, arraying
them by the magnitude of each ratio to be tested, selecting a cut off point
which will divide array into two classes with a minimum possible number of
misclassification, then computing the percentage classification error.

• The ratio which showed the least “ percentage classification error” at the
earliest possible time was deemed to have the highest predictive power.
The computation of “ percentage classification error”

• In a mixed sample of 4 sick (S) and 4 Non-Sick (N) firms with their ROI (for a given year)

arranged in an ascending order as follows:

-5 -2 3 4 6 8 10 12

S S (N) S N N (S) N

• The cut off point (arrow) is chosen in such a way that the number of misclassification

(shown in parenthesis) is minimized.

• The percentage classification error is 25% (2/8).

L. C Gupta’s study revealed that

• EBDIT/ Sales

• OCF / Sales

are the best ratios in predicting future bankruptcies.

• These ratio had the least classification error among all the profitability ratios for the textile
companies sample during 1962-64 .
Monitoring and revival of sick units[Under
Sick Industrial Act,1985]
•The co. has been in existence for at least 7
Detection of sickness years
based on three criteria •Net worth fully eroded
•Cash-losses in two successive previous years

Reporting the sickness to BIFR within 60 days from the

date of finalisation of the audited accounts for enquiry

Instituting an enquiry by an ‘operating agency’ and

submitting its findings ordinarily within 60 days
 Contd.

Not practicable for the co.

Practicable for the company to make
to make its net worth
its net worth positive ‘within
positive
reasonable time’

Giving the co. reasonable Scheme for revival

time to make its net worth (Reconstruction.
positive Amalgamation with any
other co., take-over, sale
Ref. to high court for winding or lease) within 90 days
up

The company fails

Scheme successful
(Sickness removed)

The company succeeds and the sickness is removed

Case Study on restructuring
• To study the factors responsible for CDR in power sector (Industry)
• Factors responsible for CDR in Konaseema gas power Ltd.(Co.)
• To Analyze the pre-restructuring and post restructuring financial
Position of KGPL
 CDR
•Corporate Debt Restructuring (CDR) was a method to revive companies which
are under debt and have ability to revive.

•A Corporate Debt Restructuring System was evolved and detailed guidelines

were issued by Reserve bank of India on August 23, 2001 for implementation by
financial institutions and banks.

THREE TIER
•Extension in the time period for STRUCTURE
the repayment of loan
•Reducing rate of interest for the
unpaid portion of the loan •CDR Core Group
•CDR Empowered Group
•CDR Cell
Factors responsible for CDR in Power sector
• 1. Coal shortages and environmental issues
• Constrained supplies of coal by Coal India Limited) and lack of progress in coal mining.

• 2. Gas supply constraints

• Limited production and supply of Gas

• 3. Challenges in hydro power projects

• Hydro power projects are expected to face risks on account of factors such as political and
environmental protests, delay / cancellation of environmental clearances, delays in land
acquisition, poor infrastructure, geological surprises, shortage of skilled man power, etc.
• 5.Concerns pertaining to distribution
• AT & C losses are likely to remain a source of concern for the State sector
distribution companies, thus leading to continued dependence on subsidies /
grant from the respective state governments.
• (The concept of Aggregate Technical & Commercial losses provides a realistic
picture of loss situation in the context it is measured. It is combination
of energy loss (Technical loss + Theft + inefficiency in billing)& commercial loss
(Default in payment + inefficiency in collection).

• 6.Availability of power equipment / EPC players

• There are constraints pertaining to availability of power equipment as also the
availability of quality EPC players to cater to the requirements of increasing
number of thermal power generation projects
Factors responsible for cdr in konaseema gas
power ltd
•Non-availability of adequate quantity of Natural gas to operate the plant at
projected PLF

•Delay in decision by Andhra Pradesh Electricity Regulatory Commission

(APERC) for increase in tariff rates.
 Condition of KPGL before CDR
1. Financial closure on 23rd December 2003.
2. The cost of the project was appraised at Rs. 1383 crores by IDBI Bank
3. The project was completed in the year 2006 could not commence its
operation due to non-availability of natural gas

4. In February 2009, IDBI has carried out the viability study of the
project and has re-appraised the project cost at Rs. 2035 crore, by
way of Equity at Rs. 591 crore and term debt of Rs. 1444 crore .

5. KGPL entered into Gas Sale & Purchase Agreement on April 2009 for
purchase of Natural Gas with Reliance Industries Ltd
6.KGPL commenced operations of its 445 MW power plant in June 2010
and achieved operations of 280 MW.
7.The payments towards interest commenced from July 2009 and principal
installments from April 2010 and company had not started its
production.
8.The plant has been operating at low PLF (about 30-40%) due to
insufficient supply of gas , which creates liquidity problem (insufficient
fuel supply from RIL KG Basin)
9.Delay in decision by Andhra Pradesh Electricity Regulatory Commission
(APERC) for increase in tariff/.
10.The installation of Alternative Fuel Facility will be costing Rs.110crore.
 Financial position
(Rs. Crore) Particulars FY2011 (9 months) FY2012

Income from Sale of Power 558.60 632.51

Consumption of Raw Material 370.34 480.16

Operation & Maintenance 17.88 46.48

Expenses
Total Expense 388.22 526.64

EBDITA 170.38 105.88

Depreciation 77.54 103.99

Financial Expenses 149.95 206.26

Other Income / (Expense) 10.46 (15.06)

PBT before Exceptional Item -46.64 -219.42

Tax -10.38 -9.62

PAT -57.01 -229.04

• Hence, In view of the non-availability of adequate
quantity of natural gas to operate the plant, delay
in order of state authority for increase in tariff and
additional sanction to set up alternate fuel facility
leads to liquidity problems. The company has
requested the lenders for restructuring of debt
under CDR Mechanism.
How debt redressed through CDR
 Cut-off date (COD)– May 1, 2012
• Moratorium Period of 35 months from cut off date.
• Bifurcation of Loans into different Buckets
• first bucket aggregating Rs.1130.40 crore
• The present restructuring proposal envisages reduction in the interest rate
and effective interest rate works out to be 12.59 %
• Second bucket consists Rs.204.72 Crore.
• Effective rate of interest for the tenor of the loan works out to 10.67% p.a.
• Funding of Overdue Interest on the Cut-off
date (Rs. 97.62 crore)

• Interest Overdue on the Cut-off date is proposed to

be converted into FITL. (Funded Interest Term Loan
(FITL) is giving a loan for repaying an existing loan)
It's a kind of loan restricting mechanism.
• Effective rate of interest for the tenor of the loan
works out to 10.56% p.a.
• As per the restructuring package, sacrifice
amount to the lenders work out to Rs. 174.89
crore.
• The Company shall repay the entire sacrifice
amount of Rs. 174.89 crore to the lenders along
with compensation equivalent to 225% of the
sacrifice amount. The total amount to be repaid by
the company works out to Rs. 568.38 crore from
30th April 2024 till 30th June 2025
• The sacrifices of the lenders would reduce from
Rs.174.89 crore to Rs. 77.39 crore
• As per CDR norms, Promoters have to infuse
minimum 25% of the sacrifices amount i.e. Rs.
19.5 crore. Promoters have already paid the
minimum sacrifice amount.
• Promoters’ sacrifice : additional funding
brought by promoters’ side.
Either 20 % of banks’ sacrifice or 2% of the
restructured advances.

Banks’ sacrifice:

amount foregone as an economic loss for the

bank.
Banks’ measures the loss and make provisions
for it by debit to P& L account.
FINDINGS
1.Konaseema gas power limited is operating at very
low capacity 30% to 40% due to in sufficient supply
of natural gas. The situation is likely to continue till
2014.
2.Konaseema gas power limited has taken up the
issue of increase in tariff by Re.0.51/kWh with
APERC, towards compensating loss suffered due to
non-availability of gas.
3.Net Working Capital of the company has been
negative in the past and is projected to be negative
for next 2 years. There are certain irregularity has
been observed in the Working Capital (WC) limits
of the company.
4.As per the restructuring package, sacrifice amount
to the lenders work out to Rs. 174.89 crore
CONCLUSION
• The Corporate Debt Restructuring scheme of Power companies has been formulated
taking into account the projected cash flows of the company based upon the
existing and projected financial positions

• The proposed restructuring scheme mentioned is formulated keeping in view the

best interests of the company / lenders. The scheme creates a suitable balance for
the company in terms of meeting its renewed financial obligations to the lenders
and provide adequate cushion for sustaining its operations in the long term

• With the increased emphasis in power sector by the government, the future
prospects for the power industry appear upbeat and the companies could be
expected to gain from the same