Corporate Financial Distress

Restructuring and Turnaround

Alberto Tron

• Publisher: Emerald Publishing Limited
• Year: 2021
• ISBN:
  9781839829826
• Topic: Betriebswirtschaft
• Subtopic: Unternehmensfinanzen

Financial distress in corporations is a frequent phenomenon, particularly during times of national and international economic crises; but this can be used as an opportunity and incentive to implement a systematic process of reorganization and revitalization of a business. These plans for recovery can lead to future successes and sustainability rather than just a fix to ensure survival of the business. Crises, if managed promptly from a strategic point of view, can lead to pragmatic changes and bring new value to the company, avoiding market foreclosure and the negative social consequences.
Corporate Financial Distress, Restructuring and Turnaround identifies a recovery plan, monitoring, deployment and provides tools to direct economic crises towards financial success in the future and financial stability in the short term. An analysis scheme has been developed and is provided to help measure economic, financial and strategic performance with the why, how and what in relation to the recovery plan. A model for the detection and evaluation of the economic-financial performance implemented by an execution of a recovery plan and a set of indicators for evaluating the variables activated by the process of strategic change are identified.
Tron uses alert analysis perspective to examine crises and recovery in business to outline discontinuity with the past in order to address strategic organizational changes and lead the financial process of rehabilitation towards success.

Chapter 1

Corporate Distress and Financial Equilibrium: Genesis and Prognosis

1. Introduction and Background

Research on financial distress and corporate crisis management is relatively young in comparison to studies on financially sound enterprises.

The corporate health of firms is of considerable concern for various stakeholders, such as investors, managers, policy makers and industry participants. Nowadays, the main concern of companies, regardless of their size and sector, is the threat of insolvency.

There are several reasons for this strong focus on preventing and mitigating a corporate downturn.

Traditionally, financial economics literature has portrayed financial distress as a costly event, the possibility of which is important in determining firms' optimal capital structure (Opler & Titman, 1994).

A company under financial distress is a company that is struggling with promises made to its creditors. Financial distress can be defined as the point where cash flows are lower than the firm's current obligations (Wruck, 1990).

If a company is unable to meet those obligations, it is in default (Vassalou & Xing, 2004) and its creditors may start legal proceedings to sue for bankruptcy.

This book provides evidence on distressed firms (Chapter 2) from a civil-law country, Italy, that has traditionally been considered a country with rather weak shareholder and quite strong creditor protection (La Porta, Lopez-de-Silanes, Shiefer, & Vishny, 1998).

Most existing studies have so far almost exclusively looked at the US (Altman & Hotchkiss, 2005); however, the US has a financial market that is usually characterised by stronger shareholder and weaker creditor rights if compared to Italy.

Differences in legal regimes are likely to matter for changes in corporate oversight and turnarounds.

For an Italian company in distress and heading towards default there are three options:

(1)make a deal with creditors, possibly renegotiating obligations.

(2)voluntarily file for bankruptcy, and either be auctioned off as a going concern or liquidated and sold piecemeal.

(3)file for corporate reorganisation at the local district court.

Independently of the local legal regime, this area has become of public concern due to the recent global financial crisis (2008–2009) that witnessed failures of many venerable institutions which were rescued by governments (Bear Stearns, AIG, Fannie Mae & Freddie Mac, Washington Mutual, Anglo Irish Bank, Royal Bank of Scotland, Northern Rock, etc.).

The resolution mechanisms for both the private and public sector use corporate finance paradigms to develop financial distress tools.

Both academics and practitioners have contributed substantially to crisis literature: practitioner–business managers have generally focused on how to procedures and techniques (Devlin, 2006; Fink, 1986; Regester & Larkin, 2005; Ruff & Aziz, 2003; Seymour & Moore, 2000;), while academic scholars have tended to address more theory-based response strategies, including the corporate apologetic approach (Hearit, 1995, 2006; Outecheva, 2007; Rowland and Jerome, 2004), financial distress prediction (Altman, 1968; Altman, Hatzell, & Peck, 1995; Balcean & Ooghe, 2006; Beaver, 1966; Bose, 2006; Doumpos & Zoupounidis, 1999; Foster, 1986; Kumar & Ravi, 2007; Lin, 2009; Ravisankar, Ravi, & Bose, 2010; Ross, Wesrtefield, & Jaffe, 2010; Sun & Li, 2008), image restoration (Benoit, 1995, 2000; Burns & Bruner, 2000; King, 2006) and post-crisis discourse (Coombs, 2004; Ulmer, Seeger, & Sellnow, 2007) or specialised fields such as product-harm crises (Laufer & Coombs, 2006).

Notable academics have identified and categorised different types of financial distress and corporate crises, in the belief that such categories may help in developing the most appropriate response strategies (Jaques, 2009). Lerbinger (1997), for instance, described seven categories, Coombs (1999) formulated five different ranges, while Gundel (2005) explored in detail the role and properties of crisis types.

Since first devoting its attention to the subject, academic literature has emphasised the difficulties in defining corporate financial distress because of the incomplete and arbitrary nature of any criteria in classifying it (Keasey & Watson, 1987).

There is no general consensus on how financial distress affects corporate performance, but it is costly (Opler & Titman 1994) and needs to be investigated. Altman (1993) relates corporate financial distress to unsuccessful business enterprise and defines four generic terms commonly used in literature which are: failure, insolvency, bankruptcy, and default.

Corporate financial distress remains, nonetheless, a vague term (Altman & Hotchkiss, 2005) that does not correspond to an absolute condition such as bankruptcy or insolvency.

Despite a lack of an exact agreement on crisis definition and typologies, there is at least a reasonable level of commonality. Corporate financial distress identifies a status that is extended in time, embracing the failure path and (both possibly and ultimately) the event of bankruptcy.

According to academic literature, the life of a company is characterised by positive and negative circumstances which, taking place with a certain degree of intensity, determine its economic viability (Alas & Gao, 2010; Cazdyn, 2007; Giacosa & Mazzoleni, 2011; Giannessi, 1982; Onida, 1960).

The crisis is often seen as a recurring event in ordinary corporate life (Bradley, 1978; Gcaza & Urban, 2015; Holmgren & Johansson, 2015; Kadarova, 2010; Kadarova, Markovic & Mihok, 2015; Lagadec, 1991a, 1991b; Pollifroni, 2012; Pollifroni, Militaru & Socaciu, 2014).

During the life of a company, alternation between negative and positive phases may take place either during a temporal phase (or cyclical in time) or it may be a permanent state (Amaduzzi, 1949; Bastia, 1996; Giacosa, 2016; Guatri, 1995; Paolini, 1998; Zanda, 2015; Zappa, 1956).

In a situation characterised by increasingly compressed margins of profitability, the spread of the 2008–09 financial and economic crisis caused difficulty for a lot of medium and medium-large companies to generate sufficient sales volumes to achieve at least a break-even point. Not to mention smaller companies, which found themselves facing a critical situation, without the necessary conditions and resources (not only economic-financial) to deal with it.

Academic literature has essentially been developed in two macro-areas of analysis: (1) the first is represented by studies focusing on the crisis of entire economic systems, productive sectors or geographical areas with clearly identifiable borders; (2) the second area, instead, is represented by works related to the crisis of individual entities (Danovi and Quagli, 2015; Tedeschi-Toschi, 1990).

In scholarship, sectorial crises are explained, in most studies, as a consequence of the specific weakness or physiological evolution of sectors, as well as in terms of the ineffectiveness of public support policies (Boeri, 1985, 1987; Dematté, 1979; Gros-Pietro, 1976; Podestà, 1984; Prodi & Gobbo, 1980).

Within these studies, finally, aspects of a more microeconomic nature begin to assume considerable importance as the real causes of corporate crisis, such as, for example, technological and organisational innovations related to production processes in specific sectors, or consumer behaviour related to the underlying demand trend for specific goods or services.

Negative economic situations, in fact, give rise to an acceleration of processes related to the life cycle of a company, with possible sudden changes from a situation of expansion and growth to a situation of possible contraction and crisis.

Guatri (1995) highlights, from an evolutionary perspective, that the process moving from decline to crisis includes four stages: (1) incubation, characterised by a decrease of economic and financial equilibrium; (2) periodic financial losses are significant and the entity's intrinsic value starts to fall; (3) the mean profitability affects the cash flows and the reduced credibility implies a higher difficulty of borrowing; (4) explosion of the crisis that generates serious impacts at economic, managerial and financial levels, both internally and externally (Pozzoli & Paolone, 2017).

Despite this consideration, through the analysis of case studies, the examination of internal factors as causal factors of corporate crisis seems to be predominant if compared to the study of its environmental dynamics. The literature particularly emphasises the errors made in the strategic and managerial activities of the company (Argenti, 1976; Smart & Vertinsky, 1977).

The relevance of external factors has only been highlighted in recent studies on changes in the political and social environment. Reference is made to contingent and unpredictable events with low probability, such as, for example, natural disasters and accidents at work (Billings, Milburn, & Schaalman, 1980; Lagadec, 1991a, 1991b; Reilly, 1993; Shrivastava, 1992).

An appropriate classification of the reasons that led to the crisis is crucial in order to determine an effective response. The deeper and longer the crisis, the faster and wider the reaction required. In the majority of cases, there is not only one cause for the decline and so consequently the solution is to refer to different areas of intervention.

Grant (2010) states that when the decline is prolonged, the response would likely be both strategic and financial. In this perspective, practice is progressively more oriented to providing models able to predict the phenomenon, and not only to declare its existence (CNDCEC, 2015).

The analysis of a company crisis as commonly described in literature will be carried out in the following paragraphs, starting from balance sheet data and through analysis by indices or flows. The so-called financial analysis is necessary to understand the reasons and genesis of a crisis, as well as to reveal possible solutions.

The following paragraphs introduce the complex phenomenon of corporate financial distress, illustrating its articulation in different phases of the corporate path, reviewing its definition and providing a re-assessment of the relevant academic literature and some guidelines for an optimal corporate financial structure (FS; for the prevention of financial distress).

2. Defining Corporate Distress: From Decline to Crisis

Even if some studies have provided empirical evidence underlining that there is no direct relation between economic and financial distress (Senbet & Seward, 1995; Kahl, 2002a, 2002b), an economic crisis may lead to financial and/or economic distress if contribution from stockholders is missing and if there are no corrective actions. In general terms, distress exists when the company's equilibrium cannot be reached under the current situation. If other actions are not taken, the firm is naturally destined to cease its operations. The concept of ‘economic distress’ is not very well developed. The literature most commonly refers to this concept by illustrating the aspects related to the above-mentioned economic equilibrium.

The adopted notion of corporate crisis follows a hybrid and contingent approach.

The analysis of the crisis, in fact, as well as the tools and models for its solution, cannot be formalised in a prescriptive and generalised way, as it requires a deep knowledge of the company and of the reference environment in which it operates.

This vision accepts and integrates, according to the systemic theory, the definition of crisis according to the concepts of the Theory of Value (Fruhan, 1979; Guatri, 1991; Blyth, Friskey, & Rappaport, 1986), dedicating attention also to decline situations, i.e. to phases in which the pathology is still latent in the company structure (Danovi, 2003; Guatri, 1995).

In particular, starting from the fundamental equation of value:

it is possible to define the concept of the company's decline as the achievement of a negative change in a company's economic value over time; hence the quote ‘a company is in decline when it loses value over time’.

The definition of corporate crisis proposed by Guatri, based on the Theory of Value, considers, on the one hand, the awareness that the company will inevitably face moments of crisis during its life cycle and, on the other, the understanding that the crisis may be related to corporate events, but also to changes in the external environment.

Given the fundamental equation of value (W = R/i), the crisis is correlated to a negative change in value, highlighting how decline and crisis may depend not only on a decrease in flows (internal events) but also on external events, that is a change in risk conditions (Danovi & Quagli, 2015).

A situation of company decline is not only identified by the presence of economic losses or by a reduction in the related cash flows. To have a decline situation, the economic loss must be systematic and, at the same time, irreversible if no remedial action is taken. The measure of loss should not only be calculated on a final basis but should also refer to prospective flows.

According to Guatri's approach (1995), the crisis path can be described as a sequence of four dependent stages: for each of which, specific events may be observed (see following Fig. 1.1).

Fig. 1.1. The Four Stages of Crisis according to the Traditional Appro...