The Financial Restructuring of a Company in Financial Distress

Master's Thesis, 2018

112 Pages, Grade: 5.00 (very good)



1. Introduction

2. Theoretical background and previous research
2.1 Financial difficulties
2.1.1. Levels and types of business difficulties
2.1.2. Causes of financial difficulties
2.1.3. Eliminating financial difficulties
2.2. Bankruptcy Forecasting Techniques and Models
2.2.1. Financial ratios
2.2.2. Discriminatory analysis
2.2.3. Linear probability model
2.2.5. Logit model
2.3. Restructuring of companies
2.3.1. Restructuring scenarios
2.3.2. Participants in the restructuring process
2.3.3. Stages of the restructuring process
2.3.4. Advantages of corporate restructuring
2.3.5. Operational restructuring
2.3.6. Financial restructuring
2.3.7. Restructuring techniques
2.4. Bankruptcy Law
2.4.1. The tasks and objectives of bankruptcy law
2.4.2. Bankruptcy cost
2.4.3. An example of a good bankruptcy law - Singapore

3. Research description and research results
3.1. Bankruptcy Regulation in the Republic of Croatia
3.1.1. Bankruptcy Law in the Republic of Croatia
3.1.2. Law on the procedure of extraordinary administration in companies of systemic importance for the Republic of Croatia
3.2. Basic information and business characteristics of Agrokor Group before the extraordinary management process
3.2.1. Structure of Agrokor Group
3.2.2. Agrokor Group's performance indicators for the period 2007-2016
3.2.3. Agrokor Group business performance analysis based on business prediction model
3.3. Introduction of the extraordinary management and misstatement of the Agrokor Group's transactions in the financial statements of the previous period
3.4. Agrokor Group's operations in the extraordinary management process
3.5. Costs of operations and extraordinary administration
3.6. Debt analysis
3.6.1. Debt analysis as of 31.12.2016. years
3.6.2. Debt and claims analysis during the Extraordinary Administrative Procedure

4. Discussion
4.1. Restructuring of Agrokor Group
4.2. A model for determining the order in which subjects are settled
4.3. Financial restructuring of Agrokor Group

5. Conclusion


List of tables

List of pictures

List of charts

The Financial Restructuring of a Company in Financial Distress


Every company has a unique life cycle. Throughout the life cycle, companies are tracking successes and failures, depending on the various factors that affect their business. Situations such as financial distress , idleness, or bankruptcy represent the fundamental levels of a company's life cycle. The purpose of the paper is to present the financial restructuring of the company in business problems on the example of the Agrokor Group. This paper describes the operations of the Agrokor Group from 2007 to 2017, ie it is divided into business analysis prior to the extraordinary administration and in the procedure of extraordinary administration. The characteristics of Agrokor Group's operations prior to extraordinary administration are: low liquidity and negative working capital over the observed period, extended payment of obligations to suppliers ranging from 110 to 211 days, ie 156 days on average, increased indebtedness and high indebtedness and insolvency in 2016, solid Group's activity ratios , positive profitability by 2015. With the advent of extraordinary administration , inappropriate corporate governance has been identified, and audit results show that accounting irregularities and potential illegal actions have been identified. Claims recognized amounted to HRK 31.04 b illion , while disputed claims amounted to HRK 10.4 b illio n. The Group has a financial arrangement of EUR 1.06 billion with super senior status. In addition, the complex structure of claims is emphasized. Bearing in mind all the above, the Group's financial restructuring is possible with the new corporate structure, the new capital structure, the allocation of financial instruments to stakeholders. Returns to creditors should be defined by the entity's priority model. Group value would be distributed among stakeholders based on their legal rights, ie the model's rank. The value of each claim claimed is determined by the fraction of the total distributable value that it needs to receive. After that, it will determine how many depositary receipts and the exchangeable bonds each creditor receives.

Key words : financial distress , bankruptcy , financial restructuring

1. Introduction

Each company has a unique life cycle. During the life cycle, companies record successes and failures depending on various factors that affect their business.

Businesses can have four life cycle levels:

establishment and promotion phase,

growth phase,

maturity and stabilization phase,

a stage of difficulty or bankruptcy.

The establishment and promotion phase is an early stage in which companies seek funding sources for product development and market testing. In many cases the commercialization of a company’s products or services is not fully recognized in the market. During this early stage of advancement, the goal is to market acceptance of products or services in the market.

The foundation and advancement phase is followed by the growth phase. At this stage, companies employ experienced management and satisfactory sources of financing for growth are available.

In the maturity stage, companies most often expand into new regions and / or grow through mergers and acquisitions in a vertical or horizontal direction.

However, if there is a recession or crisis in a particular industry, the company faces business problems. Many economists find it impossible for a company to grow indefinitely. According to corporate finance theory, conditions such as financial difficulties, deafness or bankruptcy represent fundamental levels of a company’s life cycle that cause certain changes in the ownership structure and rights of management of a company .

The Agrokor Group, which is currently undergoing extraordinary administration, has gone through similar phases, because by the number of employees and the amount of obligations, the company is of systemic importance for the Republic of Croatia.

The purpose of this paper is to present the financial restructuring of a company in business problems by the example of the Agrokor Group.

2. Theoretical background and previous research

Many authors have explored financial difficulties, and Altman made the most significant contribution to this topic. Financial difficulties may vary in level and type, their causes can be divided into several groups, and the remedy depends on their complexity. In order to avoid financial difficulties, a bankruptcy forecasting model can be prevented. If the business is at an unenviable level, it will be reflected in the financial statements and restructuring will be required. If the restructuring is done poorly, the company will face bankruptcy.

2.1 Financial difficulties

There are several definitions of financial hardship . Chandrashekar (2008) considers financial distress as a deteriorating condition of a company to the extent that it cannot meet its financial obligations, while the first signals of financial distress are commonly regarded as breach of contract with suppliers and payment of dividends.

Drescher (2013) believes that financial difficulties require classification. It defines a corporate crisis as an unwanted process of limited duration and control that can lead to adverse outcomes. The corporate crisis poses a significant and continuing threat to the normal business of a company or makes it impossible. The aforementioned has an adverse effect on the dominant goals of a company whose failure puts at risk the existence and independent business of the company.

Ratner (2009) divides the difficulties into operational and financial.

Operational difficulties may arise for some reasons, such as competition from other companies, competition for substitute products , departure of key employees and management, dramatic changes in raw materials (quality and availability), changes in cost structure that cannot be passed on to consumers, or changes in demand for products or services. This has financial effects such as declining revenue to lose market share. If a company in difficulty is unable to identify the causes of operational difficulties and reduce costs and increase revenues and equity (or a combination of the above), the company will experience financial difficulties in the near future, and depending on the continuity of the difficulties, insolvency.

Financial difficulties arise when a company operates with high financial leverage and is unable to reconcile debts and payments. An example of this is a company that is the subject of a high leverage transaction. Financial difficulties are also evident in companies whose capitalization does not support the operational growth of the business. For example, when a company funds long-term assets (such as plant and equipment) with short-term sources of financing. Accordingly, the business will need working capital. It should be noted the term "good company with a bad balance" which describes a company that has a strong operating business but is in financial difficulty. If a company is unable to refinance its existing debt or sell assets that do not serve its core business to meet interest costs, then the company is likely to face insolvency. It should be noted that operational and financial difficulties are not mutually exclusive, that is, a company with a strong financial position may have poor operating performance and a company with a strong operating business may have a poor financial position.

The business decline curve is a graphical representation of the challenges facing companies in difficulty during continuity. When faced with operational and financial difficulties, even experienced managers often assume that the decline is temporary and that performance will return to normal. During this phase, management will focus on monitoring the expected performance indicators and will not investigate and eliminate the main cause of business decline. This can be compared to treating the symptoms of the disease without identifying the cause. The time spent at this stage often allows the main cause to be manifest in the financial statements. Continued declines in revenue and often margins may result in increased leverage or a shortage of working capital. As the financial scope of difficulties increases, management becomes more reactive rather than proactive, and usually lacks the time and resources to address the underlying causes that led to the decline. Further decline in the curve gives the company less control over the outcome and control of the company can be taken over by creditors or stakeholders and continued in a judicial environment such as bankruptcy.

Ratner (2009) considers that the most responsible variable on the business decline curve is management, which has wasted time in denying difficulties. Excessive time spent in the denial phase makes the rest of the journey, that is, a business crash down the curve inevitable.

2.1.1. Levels and types of business difficulties

There are several levels of business difficulties for companies.

Altman (2006) has listed four terms that are encountered in the literature:

1. failure
2. insolvency
3. deaf
4. bankruptcy

Economic failure is considered when the realized rate of return on invested capital increased by provisions for risks is significantly and continuously lower compared to the returns on similar investments. It should be noted that different economic criteria can be taken such as insufficient income to cover costs or when the average return on investment is continuously less than the cost of capital of a company. Observed economic situations may be different in frequency and differently affect the survival of a company. Management decisions are based on expected returns and the ability of the company to cover variable costs. It is important to note that a company can be economically unsuccessful for many years, but that it never fails to settle its current liabilities due to the absence of debt or the absence of debt that can be recovered through legal means. Legal failure is considered when a company is unable to settle its legally enforceable liabilities. The term business failure was adopted by Dun & Bradstreet, which conducted various statistical surveys of unsatisfactory business conditions. A business failure is a company that has ceased operations after bankruptcy, one that voluntarily withdraws leaving arrears and one that is involved in some legal proceedings (eg reorganization), and one that compromises with lenders.

Insolvency shows the negative performance of a company and is used in a technical sense. Technical insolvency exists when a company is unable to meet its current obligations, which indicates insufficient liquidity or lack of liquidity. For technical insolvency, net cash flow relative to current liabilities should be the primary criterion used to describe technical insolvency, not the traditional measure of working capital. Technical insolvency may be a temporary condition, but if it becomes frequent, it can cause a formal bankruptcy. Insolvency in terms of bankruptcy is a chronic condition, not a temporary state in which a company is located. Companies are in a situation where the total liabilities exceed the fair value of the total assets and the real net worth of the company is negative. Technical insolvency is readily apparent, while bankruptcy insolvency is a condition that requires a comprehensive analysis of the valuation of a company that is not normally conducted until it has decided to liquidate the assets.

Deafness can be technical and / or legal and always involve a link between the debtor and the creditor. Technical deafness occurs when the borrower violates the terms of the agreement with the lender. This may be the basis for legal action. When a company fails to pay its liabilities on time, then it is a formal nuisance.

One form of bankruptcy is described by the negative value of a company. Another form is the formal announcement of the bankruptcy of a company with a request to go into liquidation or to attempt reorganization in bankruptcy.

Vance (2009) points out that companies can rarely go from successful business to business failure in one step. Companies in difficulty go through certain levels of business, which are gradually divided into early, mid and late levels. These levels are of diagnostic value and can assist management and interested stakeholders in preventing business difficulties.

In the early stages of financial hardship, isolated production and distribution inefficiencies become frequent and become a pattern of behavior. Consumer complaints and complaints become more frequent, sales stagnate and margins decline. The company is beginning to experience cash flow problems and current liabilities are being paid more slowly. Management still believes that the difficulties are transient and that the situation will improve in the near future. The crisis was not recognized and no corrective action was taken.

The medium level of financial hardship is characterized by problems in production and distribution that become acute. The decline in quality continued. There is a significant drop in gross margin. Material shortages occur as management seeks to increase cash flow by not procuring material and inventory. Companies are significantly late in paying suppliers, and they require prepayment. Banks are becoming concerned, therefore, requiring the development of a recovery plan. The company is technically bankrupt. Employee morale is falling and quality employees are looking for new employment. Rumors have been raised about the company's problems.

At a late stage of financial hardship, management announces the difficulties it is in and the system breaks down. Deadlines are not respected. The company is required to pay promptly. Quality control is poor. Returns and finishing of goods have increased. Efficiency declines due to material shortages and frequent schedule changes. The equipment breaks down and becomes unusable due to lack of maintenance and a lack of spare parts occurs. Consumers refuse to pay for bad services. Sales are at low levels. Credit lines are disabled. The company no longer generates cash flow. Difficulties arise in the operational and financial business, and management does not use the appropriate business measures or use them at all. The banks are desperate to close the loans and at the same time charge extra fees for defaulting on the loan. Additional collateral is required, and new loans are only possible at high interest rates. Secured creditors lose confidence in management. The best employees leave.

Newton (2009) points out that the main symptoms of business difficulties are aggravated sales and sales decline, poor cash flow, inadequate product margin and profitability, and high levels of debt. The business difficulty levels are divided into:

incubation period,

lack of money - illiquidity,

financial insolvency,

total insolvency.

The timing of each level depends on many factors. Most companies go through these levels, and only exceptions can skip a few levels. For example, some companies may be totally insolvent without being liquid.

During the incubation period, it is emphasized that companies cannot suddenly become illiquid or insolvent. Some business problems can be like a cold and be cured with the right medication, while others, if left untreated, can result in fatal or death, bankruptcy and liquidation in the business world. During the incubation period, adverse conditions are difficult for management and stakeholders to see.

Some of the unfavorable business conditions that can seriously impair the company's operations are:

changes in product demand,

continuous increase in production costs,

outdated production methods,

increasing competition,

incompetent management in key positions,

takeover of non-profit affiliates,

excessive expansion with a lack of working capital,

business with a small number of credit institutions.

It is often seen at this stage that return on investment is significantly lower than average returns in the past. Management should identify the causes of deviations and correct them, and if they cannot be corrected, they should look for alternatives. Re-planning is very effective and efficient at this stage. Furthermore, business correction decisions are not as drastic as in the stages of progress of difficulties. Public confidence will not be undermined if corrective action is taken at this stage. This is crucial because with the disturbed confidence many participants will not look favorably on the business of the company.

In the phase of liquidity or lack of money to settle current liabilities, companies for the first time encounter the inability to pay overdue liabilities. The problem may become even greater if the company owns illiquid and hard-to-market assets.

Financial insolvency occurs when a company is unable to obtain the necessary funds to meet its obligations. This level can be adjusted. It should be emphasized that the resolution measures will be long-term and uncomfortable. These measures may include, for example, changes in financial policy, changes in management or share issues, and long-term borrowing.

Total insolvency is a situation in which liabilities exceed the value of assets. At this stage, the general public and those lenders who have not yet observed the right situation for the first time realize that society is failing. Society can no longer deny ruin. At this stage, creditors may allow restructuring or take control of the company.

According to Drescher (2013), the characteristics of the corporate crisis are:

Failure to meet dominant goals such as maximizing shareholder value through two conditions. The first is long-term and implies competitive advantages of a company such as cost or production differentiation advantages or a unique combination of resources. The second is short-term and involves the signaling of insolvency and insolvency and excessive indebtedness that must be eliminated in order to preserve the company.

Existential threats that imply the smooth running of a company is that it does not threaten it with difficulties that will threaten its existence.

Ambivalent outcomes imply that the corporate crisis does not automatically lead to a company shutdown. Instead, the crisis can be an opportunity and a signal to create sustainable value for shareholders.

Complex decision-making conditions imply decisions made under time pressure and a reduced degree of freedom. The decision-making environment is characterized by high uncertainty.

The perspectives of the process imply that the return of a company under normal business conditions does not occur at one time, but has the characteristic of continuous progress in successive phases where each phase has specific characteristics. As each stage has its own peculiarities, so do the crisis indicators vary according to the different stages in which the company is located.

Degree of existential threats over time. Degrees of existential threat can be divided into:

normal and conditions,

strategic crisis,

profitability crisis,

liquidity crisis,


Initially, under normal conditions, action opportunities are high and the need for action is small. As time goes by and the company progresses in the level of difficulty, action opportunities narrow and the need for action increases.

2.1.2. Causes of financial difficulties

The causes of financial difficulties are specific to each individual company. It is very often not possible to isolate just one cause of financial difficulty due to its high complexity. One of the reasons is the complexity of multiple-causation ( pluricausality ) because many factors interact in causing financial difficulties. The second reason is the hierarchical relationship between different patterns. It should be noted that the causes cannot be attributed solely to endogenous or exclusively exogenous factors.

Drescher (2013) divides the causes of financial distress into endogenous and exogenous ones.

By endogenous factors, he considers the internal issues of an individual company, which may be for example operational efficiency or leverage, attributable to managerial responsibility.

By exogenous factors, it considers what is happening outside the company and affect a larger group of companies in the market. They can be categorized into several groups. Therefore, exogenous factors may be:

economic changes,

competitive changes,

government restrictions,

social change,

technological changes.

It should be noted that management's responsibility can also be considered as exogenous factors, because the role of management is usually considered to be the prediction of adverse external factors and reactions to them if at some point possible.

It is pointed out that several studies investigate the impact of endogenous and exogenous factors. A large group of studies cites poor management performance as a major driver of financial distress. Some authors investigate the financial difficulties caused by adverse exogenous factors. The aforementioned studies investigate the dominant reason leading to financial difficulties, however, as noted previously, there is an interaction of these factors that must be considered. Some studies analyze the causes of financial distress as an interaction of endogenous and exogenous factors depending on the economic cycle and external shocks. The aforementioned results should be interpreted with caution as the selected sample of companies and the economic environment should be taken into account.

Gaughan (2015) states that, based on Dun & Bradstreet's research on the causes of business failure presented in Table 1, three common factors have been identified.

The factors listed in order of frequency are:

economic factors (weakness in the industry),

financial factors (insufficient capitalization),

managerial inexperience (insufficient management knowledge).

The last factor concerns the role of managers in management skills in preventing bankruptcy.

Table 1 . Causes of Company Failure

Abbildung in dieser Leseprobe nicht enthalten

Source: Gaughan, PA, 2015. Mergers, Acquisitions, and Corporate Restructurings. Sixth Edition hours Hoboken, New Jersey: JohnWiley & Sons, Inc., p. 436.

The age of a company is also affected by failure. According to Dun & Bradstreet's research, it is also concluded that 30% of companies fail in the first three years of their operations.

Gaughan (2015) points out that financial difficulties and bankruptcy are related to high leverage acquisitions that occurred in the 1980s.

The same author points to the research on recapitalization through leverage that took place from 1984 to 1988. It defines leverage through equity as a transaction of new debt for payment to shareholders. The results show that 31% of leveraged companies found themselves in financial difficulty.

Other research has led to the conclusion that high leverage transactions failures are due to overpayments and poor financial structure. Surveys conducted in 1990 and 1991 indicate that recession and legal regulation are very important factors in the failure of companies.

It was also concluded that firms in difficulty have similar characteristics, which are higher debt levels and low interest coverage. Companies in difficulty also require more money than those in difficulty. This leads to companies in difficulty having to sell an average of 6.3% of their assets compared to those that are not in difficulty requiring the sale of 3.6% of their assets. Companies in difficulty had to achieve major business improvements after agreeing with creditors. For example, they should have achieved an average increase in operating income of 41.8% relative to firms in difficulty (18.9%).

The recession of 2008 and 2009 indicates that debt pressures affect cash flow, that is, its lack, because the re-generation of cash flow through the sale of assets takes place in poor conditions to achieve the optimal price of the assets from which the cash flow would be repaid.

Newton (2009) points to a similar pattern when exploring recessions over the years. Bankruptcy was felt in 1991 and continued to decline until 1996. In the same year and 1997, the number of bankruptcies increased slightly. However, during 1998 the number of bankruptcy claims dropped to the lowest levels in 20 years. Economic growth continued for the next eight years. The lack of liquidity in 2007 caused a 44% increase in bankruptcies and a 40% increase in bankruptcies in 2008. According to research relied on by Newton (2009), the causes of financial difficulties are:

- lack of good business planning - 78%,
- Excessive optimism about required funds and sales - 71%,
- not recognizing or ignoring weaknesses and not eliminating them - 70%,
- insufficient and irrelevant business experience - 63%,
- insufficient skills in managing and understanding the importance of cash flow - 82%,
- under-capitalization - 79%,
- sales at an inappropriate price - 77%,
- insufficient marketing activities - 64%,
- misunderstanding and ignoring the competition - 55%,
- Excessive exposure to one customer - 47%,
- inadequate job delegation - 58%,
- employment of inadequate staff - 56%.

Other research it relies on as causes:

1. starting a business without clearly defined reasons,
2. insufficient management skills,
3. lack of capital,
4. bad location,
5. lack of planning,
6. excessive business expansion,
7. no internet access, or website,
8. poor product quality.

That is, to prevent financial difficulties, he states:

- operating at a proven location,
- tried / true product,
- good management.

Taking all of the above into account, Newton (2009) divides the causes into internal and external causes, which are shown in Table 2.

Table 2 . Causes of business difficulties

Abbildung in dieser Leseprobe nicht enthalten

Source: author development by : Newton, GW, 2009. Bankruptcy and insolvency accounting. Seventh Edition hours Hoboken, New Jersey: John Wiley & Sons, Inc., p. 34-43.

Failure to approve loans by companies may result in deafening of its debtors. This may cause the creditor company to be unable to pay its obligations to its own creditors, which may cause a domino effect. Manufacturers usually credit distributors to increase sales. In order for distributors to be able to repay debts to the manufacturer, they must credit customers. Buyers must offer lower and lower prices in order to use and hire their equipment and machinery. Accordingly, the credit chain is progressing and increasing. If only one link goes bankrupt, a serious problem arises for all links in the chain. Failure to establish adequate credit margins can also lead to a crisis.

The answer to these potential problems would be to increase the exploration of borrowing options and, if possible, to prevent the sale on credit. Many companies believe that this would lower their sales volume even more than the cost of the loan. An unusual bankruptcy can cause serious financial problems for a company, and could be avoided by a more careful credit policy. Management's decision to approve loans without discrimination or conditions causes a serious risk to the financial stability of the company. Unusual credit losses can severely weaken a company's financial structure so that it is unable to continue operating. Similarly, high yields on bonds cause an increase in bankruptcies.

Companies often end up in bankruptcy due to lack of managerial experience, skills, initiative. Indicators of companies' failure opportunities include management's failure to monitor technological change, lack of education and lack of experience in the business sector they deal with. Inefficient management is the cause of most business failures. This category also includes the lack of coordination of management in effective communication with experts. Given the high complexity and specialization of the business, complete alignment and cooperation becomes necessary. All management services must be integrated to maximize profitability. Research often shows that business failure could be avoided by appropriate effective managerial control.

Today's environment can change in a very short time. Failure to adapt to technological advances in production can result in higher production costs compared to competitors. At the same time, companies may become overconfident and not overly concerned about manufacturing innovation. Likewise, companies should not ignore improving marketing strategies.

Many companies concentrate marketing and production opportunities on the wrong product or the wrong product group because of inadequate cost information. An accounting-based costing system can help management choose the right product and / or product line and eliminate unprofitable ones. Businesses need to maximize profits by maximizing their engagement with the highest-earning products, rather than those that are most involved in sales volume.

Most authors consider excessive expansion to be the number one cause of company failure. Over-expansion can be a strategic cause of failure through over- diversification in many unknown areas. After losing losses in diversified areas, large companies decide to focus on what they are best at. Complex business can become vulnerable to the business of small and specialized companies. If something goes wrong, knowledge of one's business becomes crucial. Excessive operational expansion exists in companies that have an internal growth problem. Many bankrupt companies have focused on increasing volume at the expense of margin and profitability. However, growth is a key goal for successful businesses that have the right managerial, financial and physical resources.

Inadequate sales may be the result of poor location or inappropriate sales organization, poor promotion or inferior product or service. This may mean an inability to generate profits for a business to continue in business.

Improper pricing refers to a price that does not cover production costs.

Excessive operating costs result in high levels of coverage, which means that a company has to sell a relatively large number of products before it can make a profit.

Inadequate working capital values are often the result of high short-term debt that has been used to invest in fixed assets. Lack of working capital often results in a deafness in the payment of liabilities to creditors. It also mentions an inappropriate dividend policy because the company runs out of cash that it gives to shareholders and thus results in cash outflows.

An imbalanced capital structure indicates an unenviable debt-to-equity ratio. If the capital structure is dominated by bonds or similar debt securities, the firm's fixed expenditure will be high. This can be a positive thing if the company makes a profit on a sound basis. However, if a company runs into difficulties, this can reduce its cash flow. High leverage acquisitions may end up failing several years after the acquisition is complete, due to a lack of working capital and an imbalanced capital structure.

Insufficient insurance coverage relates to losses resulting from force majeure such as natural disasters but also theft. If previous events occur and the company has not adequately protected its assets by securing it, it will incur significant losses.

Unless the company has clear document retention procedures and accounting methods, management will make decisions based on the wrong information.

Extremely large business growth also requires large amounts of cash, ie adequate cash flow management. The stated demands of society cannot be fulfilled in a short time. Under these conditions, meeting predefined requirements is often achieved at high costs. Poor management of interest costs, over-indebtedness and lack of support for sales and production result in inadequate use of resources and failure. Businesses that grow at steady rates are more likely to succeed than those that grow at very high growth rates.

Excessive exposure to one client or a smaller group of clients may cause business difficulties if one of the clients goes bankrupt.

Some authors believe that inactive management is a greater cause of financial distress than poor management. In other words, failure is caused more by inaction than by bad action. Symptoms of inactive management are incomprehensible and unfinished business plan or business strategy, lack of timely decisions, high rate of leaving the company by competent employees, limiting knowledge of their clients and market conditions, and inadequate delegation of authority.

Lack of management depth is about reducing the number of managers. If companies reduce the number of managers, they may face a shortage of managers who have the appropriate knowledge, skills and experience at all levels of the organization.

Too much bureaucratic management develops most often with mature companies. The signs of such management are:

low criticism tolerance,

business is safe and stable, not enterprising,

limiting capacity to solve challenges and problems,

old wisdom is passed on to younger management, forcing the way of thinking in an outdated way,

relying on old ways to solve problems in new situations,

actions are carried out without thinking of the consequences.

Imbalanced strategic management is most commonly encountered in companies whose management consists of the type of personnel that is homogeneous. An example of this type of management structure is that of Chrysler in the 1970s, which consisted mostly of engineers. Turnover management specialists often point out that imbalanced management lacks a finance specialist.

Lack of capital is an internal cause of financial difficulties and is explained in the analysis of the causes of financial difficulties in previous authors.

Fraud is the cause of a small number of bankruptcy proceedings. The reasons for false bankruptcies are that many dishonest persons want to profit from the beneficial benefits of bankruptcy proceedings without fear of prosecution.

There are some external reasons that cannot be influenced by a company. Current decisions that lead to failure are not the essential reason for failure. Companies often refuse to file for bankruptcy until they are forced by creditors. Banks can block a company account and settle debts from a company account. Normally, banks will not use this option until the company is financially in a very weak position.

Changes in competition often cause failure and financial difficulty for successful companies whose competition comes from unforeseen sources. A good example is Wal-Mart, which has driven small businesses out of the market and when it introduced toys sales over the holidays, has taken over Toys R Us consumers.

Governmental influence on business often occurs when business regulations, standards, and other business conditions change. Companies that are slow to adapt to changing business rules due to the nature of their business may find themselves in financial difficulty and even bankruptcy.

Combining social change with competition changes can easily push companies into bankruptcy if the company does not adjust. For example, one of the social changes is the relaxed attire of business people, which has affected the manufacturers of suits that, if they did not adapt to these changes, could easily end up in bankruptcy.

Technological changes often cause corporate bankruptcies due to the inefficiency of management in adapting and using them. The impact of technological change can often be controlled, but in some situations management may lose control and be unable to adapt to them. For example, sometimes technological changes do not improve products, but bring product substitutes into the market that are much more efficient, cost-effective and cost- effective.

Chandrashekar (2008) points out that the causes of financial difficulties are:

Short-sighted management,

Internal controls failed,

Capital structure,

Currency and interest rate shocks.

Myopia management refers to the problem of the agent and the principal, that is, the agency problem. With this problem, management can benefit shareholders. In the literature, remuneration of the management of the stock package is considered as a solution to this problem. When management owns the shares of a company it manages, it begins to think like a shareholder, and the shareholder's goals and objectives begin to align. Proponents of behavioral management theory believe that some phenomena can be described using models in which agents are not completely rational.

In the case of unsuccessful internal control, companies are considered to seek to avoid the discipline mechanism. Ownership changes in mergers and acquisitions generally add value to shareholders. Thus, some studies in America show that mergers and acquisitions are often the most successful shareholders of a listed company. In some countries, if the market is efficient, effective and developed, the market serves as one way of controlling where well-run companies will be rewarded and badly managed punished. However, the market is not efficient, effective and developed in all countries and market control is not fully possible. An example of a failed internal control of efficient, effective and developed markets is that of Enron. As Enron is an energy company, its operations depended on the movement of prices for energy commodities and products on the market. To protect its business against volatility in gas prices, Enron has begun to use derivatives or financial instruments whose values depend on one or more underlying variables. Because derivatives were used in large quantities, Enron became exposed to derivatives whose trading increased Enron's revenues . The aforementioned trading took place through the OTC derivatives market, which is largely unregulated, and accordingly Enron's trading became unregulated. By leveraging the unregulated market, Enron was able to hide the losses of speculative investing, the debts caused by the unprofitable business of its wholly owned companies, and to increase the value of the unprofitable companies.

According to modern financial theory, companies that invest a lot often borrow in the short term to preserve financial flexibility and protect lenders from greater uncertainty in the future of business. Growing companies should use relatively low levels of debt to counteract the problem of underinvestment . Companies in the mature phase of a business whose value derives from the assets they own have a lower cost of bankruptcy. Such companies may have higher leverage ratios to avoid cash flow problems. Companies should avoid the combination of high operating leverage leading to high business risk and high financial leverage leading to high financial risk. Revenue growth is driven by good times due to the presence of fixed costs and debt, but profits will fall in bad times for the same reason due to interest payments on debt and other financial expenses.

An example of currency shocks and interest rates is evident with steel companies in Asia. The listed companies operated with high leverage, their debt structure was also bad. When the domestic currency devalued, foreign currency debt rose. If the central bank wants to stabilize the currency, it can increase interest rates. This will adversely affect the profitability of the companies.

Altman (2006) considers that one of the main reasons for financial difficulties is the inability of management. The reason is the lack of money, that is, poor cash management. In addition to these basic reasons and causes, the same author cites some other reasons for financial difficulties:

chronically sensitive industries,

deregulation of key sectors of the economy,

high interest rates over a period of time,

international competition,

overcrowding of the industry,

increased use of high leverage in business,

high rate of entry of new businesses into the market over a period of time.

The consequence of deregulation is the reduction of barriers to entry and exit in a particular sector of the economy. The opening of new companies is associated with optimistic expectations about the future, but the incidence of bankruptcy of start-ups is significant.

2.1.3. Eliminating financial difficulties

It has been stated previously that companies are going through several levels of financial difficulty. In their early stages, companies have a wide range of decisions to make when dealing with financial difficulties.

Ratner (2009) outlines some of the options for resolving financial difficulties:

sale of part of the company,

strategic merger or acquisition,

attracting fresh capital,

offer to replace debt with ownership,


extension of debt maturity,

exchange of debt for debt, debt for shares or debt for debt and shares.

Unless the company eliminates financial difficulties, it will face bankruptcy and restructuring in bankruptcy or liquidation.

2.2. Bankruptcy Forecasting Techniques and Models

Bankruptcy forecasting techniques and models most often involve calculating various financial ratios and using models based on them. When creating a model, the most common companies fall into two groups: successful and unsuccessful. Success and failure are defined differently, depending on the researcher. Some bankruptcy forecasting techniques and models require quantitative and others models qualitative elements. There are models that require a combination of the above elements.

2.2.1. Financial ratios

In his work, Zopounidis (1998) points out authors who believe that financial ratios are good indicators for assessing companies that are at risk of bankruptcy. In his work Fitzpatrick (1932) concludes that the risk of failure is shown by the trend of the ratio: the share of net income in relation to the net worth of the company and the net worth of the company in relation to debt. In their research, Wilakor and Smith emphasize the importance of the ratio of: working capital to total assets. Merwin (1942) points out three important ratios that can be predicted for failure, analyzing them six years before failure: working capital in relation to total assets, net worth of society in relation to total debt, current assets in relation to current liabilities. Beaver (1966) points out the significance of the ratio: cash flow in relation to total debt, net income in relation to total assets, total debt in relation to total assets. Beaver's method has been criticized for not giving clear signals in predicting failed societies.

2.2.2. Discriminatory analysis

"Discriminant analysis is a multivariable analytical method of data analysis. This method is used in a variety of research and includes the company and described vector X elements measure n independent variables x. For two populations (unsuccessful and healthy companies ), it is assumed that the independent variables are distributed within each group according to the multivariate normal distribution with different means, but with the same dispersion matrix . The aim of this method is to achieve a linear combination of independent variables that maximize inter-population variance relative to group variance. The method estimates d the discriminant function, which is the coefficient vector A ( a l , a 2 , ..., a 3 ) and the constant expression a o . " ( Zoupounidis , 1998: 9)

The most famous discriminant analysis is Altman's Z- score . In bankruptcy prediction he used ratios. He sought to identify a number of ratios that best predicted bankruptcy. His research covered thirty-three bankrupt companies and thirty-three successful companies. The Altman model takes the following form:

Z = (1,2X 1 ) + (1,4X 2 ) + (3,3X 3 ) + (0,66X 4 ) + (1,0X 5 )

where is

X 1 = Working capital / Total assets

Working Capital = Total Current Assets - Total Current Liabilities

X2 = Retained earnings / Total assets

X3 = EBIT / Total Assets

EBIT - profit before interest and tax

X4 = Market value of principal / Book value of debt

The carrying amount of debt is equal to the sum of current and non-current liabilities . X 5 = Sales / Total Assets

The interpretation is as follows:

Z value greater than 2.99 - Societies never fail,

Z value below 1.81 - societies always fail,

A z value between 2.99 and 1.81 is called the zone of ignorance or indeterminacy. Companies in this zone have an uncertain future.

It is important to note that companies whose shares are not publicly traded are not suitable for valuation based on the original model because they do not have information for variable X4. To solve this problem, the model was re-evaluated:

Z '= (0.711X 1 ) + (0.847X 2 ) + (3.107X 3 ) + (0.42X 4 ) + (0.988X 5 )

Where X 1 , X 2 , X 3 , and X 5 are the same as before and X 4 is defined as

X 4 = Net worth (book value of principal) / Total liabilities

The interpretation is as follows:

Z value above 2.90 - Societies fail,

Z below 1.23 - companies will end up bankrupt,

Z value between 2.90 and 1.23 - zone of ignorance.

Zopounidis (1998) points out in his paper that Eisenbeis (1977) defined seven major problems of Altman's Z value:

1. Violation of the assumption of normal distribution of the variable,
2. Using linear instead of quadratic discriminant function, when the groups of dispersion matrices are not equal,
3. Inadequate interpretation of the role of independent variables,
4. Dimensionality reduction ,
5. Group definition,
6. Inappropriate choice of probability and / or inappropriate classification,
7. Problems in estimating classification error rates to evaluate model performance.

This classification, while important, does not provide any assessment of the risk of society failure. Based on this idea, the next step in predicting failure was to use methods and models that are able to provide the probability of failure.

2.2.3. Linear probability model

Gujarati (1988) detailed the linear probability model. The method assumes that the variable y that represents the affiliation of a company and in one of the specific groups, is a linear combination of n characteristics of the company. Transforming the probability of Pi of a failed society is:

Abbildung in dieser Leseprobe nicht enthalten

Where are they:

a 0, a 1,…, a n estimated

x i1, x i2,…, x in are n independent variables for society i

Zoupounidis points out that the errors are heteroskedastic and their distribution is not normal. There is also a problem of interpretation in a way that predicts a probability value that lies beyond the interval (0-1 ).

2.2.5. Logit model

The Logit model is useful for classifications when the dependent variable is binary in nature, that is, there are only two possible values - the company has no business problems (0) or has (1). In the logit model, the predicted values of the dependent variable will never be less than or equal to 0, or greater than or equal to 1, regardless of the value of the independent variables. (Novak, 2007: 45)

Logit Model Expression :

Abbildung in dieser Leseprobe nicht enthalten

Zoupounidis (1998) points out that the logit model has achieved significant results in determining successful and unsuccessful companies, and models have been developed in many countries.

2.3. Restructuring of companies

There are several types of restructuring. Lopez (2014) believes that a company needs restructuring when faced with economic and financial difficulties. He finds it difficult for a company when it is unable to generate cash flow to fulfill its obligations to suppliers. For him, restructuring means making changes to make society liquid and profitable. Any restructuring of a company involves financial restructuring. Financial restructuring may not necessarily be related to refinancing. The aim of any restructuring is to introduce changes to generate free cash flow to meet liabilities and satisfy shareholder appetites. The restructuring process is a negotiation process, so it is necessary to understand the interests of all stakeholders.

Lopez (2014) considers that a company is in difficulty when it is unable to settle its obligations to suppliers, that is, there is no free cash flow. Under free cash flow, the money generated by the operating business of a company is considered, and its calculation is shown in Table 3.

Table 3 . Free Cash Flow Calculation

Abbildung in dieser Leseprobe nicht enthalten

Source: Lopez Lubian, FJ, 2014. The Executive Guide to Corporate Restructuring. New York: Palgrave Macmillan., P. 6.

From an economic point of view, it cannot be said that a company that generates free cash flow to settle its liabilities is sustainable. If the situation is as stated above, the shareholders of the said company will be at a loss because the company will spend money intended for them. The calculation of free cash flow to shareholders is shown in Table 4.

Table 4 . From the free cash flow of the company to the free cash flow to shareholders

Abbildung in dieser Leseprobe nicht enthalten

Source: Lopez Lubian, FJ, 2014. The Executive Guide to Corporate Restructuring. New York: Palgrave Macmillan., P. 7.

Accordingly, a company is viable if it generates free cash flow to settle obligations and to compensate shareholders for the expected return on their investment.

It is important to distinguish economic profitability from accounting profitability. Accounting profitability is usually shown by return on equity (ROE), that is, the book's ratio of income to book equity. Economic profitability is determined by the real cash (cash flow) that shareholders receive from the company. Economic profitability is measured by the internal rate of return of free cash flow to shareholders, which means that it is the free cash flow remaining after all debt service obligations have been settled.

A company can achieve very high rates of accounting profitability, but a very low rate of economic profitability. This is a result of the reduced cash flow from operating activities, which can be offset by an increase in borrowing. This is a sign of diminishing profitability and financial vulnerability of the company. If this situation is repeated continuously, it will lead to an inevitable restructuring of the company.

Accordingly, restructuring involves the implementation of improvements in asset management and capital structure, not just a change in the terms of debt repayment and debt settlement.

Lopez (2014) points out that restructuring is needed for two main reasons:

1. serious threat to liquidity arising already from a significant drop in revenue and / or due to a significant increase in costs that threaten the survival of the company and its ability to meet its operational and financial obligations and in the short term ,
2. a severe decline in the market value of the firm's strategic assets, which in turn affects the collateral value of the assets.

Restructuring is usually divided into financial and operational restructuring.

Financial restructuring is an agreement on the future conditions for the settlement of obligations of the company in order to create conditions for sustaining the life of the company due to lack of funds. It is an agreement on how a company can generate cash flow and how it will be distributed to pay off creditors to avoid bankruptcy or liquidation depending on the level of business difficulties. Restructuring involves measures to optimize the scope of a company and generate its cash flow.

Lopez (2014) considers the key features of restructuring to be:

the restructuring process consists of reaching an agreement (private or legal or bankruptcy or bankruptcy),

restructuring implies a special refinancing agreement in the face of business difficulties where financial tensions are present,

the aim is to provide the company with a sustainable business and ensure continuity,

only makes sense if the value of the debt is greater after the restructuring than the value of the company in liquidation,

the assumption is that certain operational restructuring measures have been taken but have proved insufficient to generate the necessary cash flow to avoid financial difficulties.

2.3.1. Restructuring scenarios

Restructuring scenarios depend on the financial situation of the company. If the company is not in difficulty, the restructuring procedure will be private and will simply be refinanced. If a company is in difficulty and opts for a private procedure, it will decide to restructure. When a company decides on a legal procedure, the result will be bankruptcy. The company can survive bankruptcy by restructuring in bankruptcy, it will have to reach agreements with creditors on the terms and manner of repayment of debt, or a repayment plan and bankruptcy plan will be drawn up. If the bankruptcy restructuring fails, liquidation will follow.

Bankruptcy restructuring involves agreements with a large number of participants who have their own interests. It is about the distribution of the generated cash flow, that is, the manner and the order in which the company will fulfill its obligations towards the creditors.

2.3.2. Participants in the restructuring process

The stakeholders in company restructuring are:

employees whose interest is stability,

shareholders whose interest is the value of the shares,

creditors whose interest is the value of debt,

customers interested in quality of service, distribution and other conditions,

suppliers whose interest is the ability to meet company obligations,

only a company whose interest is survival,

the public whose interest is the restructuring process, especially if the company is of great importance to the economy.

Table 5 shows the participants in the restructuring process and the ways of acting on individual participants in order to achieve the goal or improvement of cash flow in the short and medium term. Trading partners may be required to extend payment deadlines and write off debts, and clients agree to extend delivery times.


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The Financial Restructuring of a Company in Financial Distress
Josip Juraj Strossmayer University of Osijek  (Faculty of Economics in Osijek)
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financial, restructuring, company, distress
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MA Drago Dević (Author), 2018, The Financial Restructuring of a Company in Financial Distress, Munich, GRIN Verlag,


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