Special Feature:
Financial Distress:
Theory, Measurement & Consequence
(A Seminar Paper
Presented at the Catholic University
of Eastern Africa, Department of Commerce on 10th November 2000)
Jonah Aiyabei*
Introduction
Prediction and
analysis of corporate financial performance is a crucial phenomena in a developing
country like Kenya in the light of recent closure of businesses such as banks
and insurance companies. Other firms have been put in receivership, and even
individuals declared bankrupt. There is an increasing trend of failure of
Kenyan businesses such as KCC and KENATCO are examples of these.
A business core
aim is to generate profit and by extension, maximization of wealth. In the
course of operations, however, a firm might experience financial problems
caused by both internal and external environmental factors. These financial
factors lead to what we refer to as financial distress.
Wruck (1990) defines
financial distress as a situation where a firm's operating cash-flows are
not sufficient to satisfy current obligations (such as trade credits or interest
expenses), and the firm is forced to take corrective action.
The consequence
of financial distress may include a firm's default on its contracts. It may
also involve financial restructuring between the firm, it's creditors and
shareholders. Actions taken by a firm under financial distress are often circumstantial
and ideally would not be taken if the firm had sufficient cash flow.
Rose et al (1996)
linked financial distress to insolvency and defined it as:
"Inability to pay
one's debt and lack of means of paying one's debts. Such as a condition of
a woman's (or man's) assets and liabilities that, the farmer needs immediately
available would be insufficient to discharge the later."
Altman (1983) distinguished
between stock-based insolvency and flow-based insolvency all of which leads
to financial distress. The former occurs when a firm has negative net-worth,
causing the value of its assets to be less than the value of its debts. This
can be illustrated by a balance sheet equation as follows:
Assets < Debts
——— (for a insolvent firm)
Assets = Equity
+ Debts —— (for a solvent firm)
Flow-based insolvency
occurs when a firm's cash flows are insufficient to cover contractually required
payments. Altman illustrates this concept as shown below:
Figure 1
Financial literature
has devoted significant attention to issues of measuring, avoiding, and consequences
of financial distress based on data from developed nations. A review of literature
(see Bibeaults, 1982; O'Neill, 1986; and Robin and Pearce, 1992) reveals a
wide range of research on the issue among developed countries. There is a
need to explore small business financial performance evaluation during the
life cycle of an entrepreneurial firm in a developing nation such as Kenya.
The purpose of this paper is to:
i) discuss the financial performance
based on the financial life cycle
ii) explore
the signs of financial distress
iii) address the
issue of how firms deal with financial distress and present a model of measuring
financial distress.
Theoretical Framework
A cyclical concept
of performance can be used to describe the financial life cycle of a firm.
This concept has been used in marketing literature to describe the product
life cycle (Kotler, 1995). Rasheed (1997) used a financial life cycle model
to describe financial performance over time as illustrated by figure 2 below:
Figure 2
The shape of the
curve suggests cyclical variation in financial performance over a continuum
of time. The vertical axis represents financial performance as a univariate
measure. The two most used variables in financial literature are return on
sales (ROS), or return on assets (ROA), (Ramajam, 1984). These measures are
generally referred to as return. The horizontal axis represents time (n) in
reporting periods (usually years). The intersection of the horizontal axis
represents a break-even point. The first stage of the financial life cycle
(FLC) is the startup phases. This is characterized by financial returns below
break-even point. The second stage, growth, represents returns greater than
zero. The stagnant is a situation in which a firm has stabilised and has a
market niche. Turn around is a period of poor performance followed by increased
returns.
A firm experiencing
an extended crisis period will often end in distress, which eventually may
result in voluntary or involuntary liquidation (Klutie 1991). Application
of this operational cyclical model is logical for a Less Developed Countries
(LDC) such as Kenya, due to limited resources to withstand long periods of
poor performance.
Quantitative Measures of Financial Performance
The typical univarite
measures of financial performance have been return on sales (ROS) or Return
on Assets (ROA). ROS is calculated as the earnings before interest and taxes
divided by next revenue. ROS is commonly referred to as operating profit margin.
Return on assets (ROA) is defined as earning before interest and taxes divided
by net book value of assets. Other statistical methods of assessing the potential
for failure have been used in financial literature. Some measures are combinations
of financial ratios.
For example, Beaver
(1967) proposed three univariate model financial ratios that measured profitability,
liquidity and solvency.
Rasheed (1997)
noted that the most statistically significant results in predicting bankruptcy
(read distress) have been produced by multivariate models. The model proposed
by Altman (1968) combines various ratios. He used Multiple Discriminate Analysis
(MDA) to discriminate between characteristics of a financially distressed
firm and a non-financially distressed one combining traditional ratio analysis
with statistical techniques. MDA analyses the entire variable profile of the
object simultaneously rather than sequentially examining individual characteristics.
Combinations of ratios are analyzed together in order to remove possible ambiguities
and misclassifications.
Altman (1968) suggested
that this model can predict ultimate of distress as much as two reporting
periods prior to the event. He revised the original Z score model of 1968
in 1983 to make it suitable for all firm sizes, hence it can be applied for
small size firms in developing countries. The standard regression model he
developed is as below:
Z=6.5(X1)+3.26(X2)+6.72(X3)+1.05(X4)
Where X1 =
Networking Capital
Total Assets
X2 =
Accumulated Retained Earnings
Total Assets
X3 =
EBIT
Total Assets
X4 =
Book Value of Equity
Total Liabilities
The critical categories
used by Altman to predict financial distress, based on Z model, are as follows:
For Z < 1.10 indicates a firm in a financial
distress zone
Z = 1.10 to 2.60 a firm in gray zone
Z > 2.60 a firm is a non bankruptcy zone
Altman's model was used to predict bankruptcy for small
businesses. This paper suggests that the multivariate models using Z score
can be used to measure financial performance in Kenya. There is a need to
compute the Z score on date from Kenyan institutions such as banks. This can
further be used to demonstrate the following proposition:
1. How firms can predict financial distress
as measured by Altman's Z score in Kenya.
2.
What action firms should take when they are in various zones of the
Z score as indicated by Altman.
Indicators of a Financially Distressed Firm
1. Dividend reduction:
A company which has shown a continuous decline in amount of dividend over
time, or even failed to declare dividends at all.
2. Plant closing:
A financial distressed company may not support all its plants leading to closure
of some branches. In the last four years, Kenya has witnessed its banking
industry closing some branches which do not break-even.
3. Losses: Operating losses make a company not to pay dividends or increasing
investment. A loss is a reduction in capital, hence the company moves towards
bankruptcy.
4. Lay offs: In Kenya, retrenchment has affected both the public and private sectors.
Companies such as Barclays Bank, Standard Chartered, National Oil Corp, etc,
are laying off their staff.
5. CEO resignations:
The top managers of an organization are well placed to see much ahead of time
the performance of their organizations. They can therefore resign and move
to firms that show potential for withstanding economic hardship. This resignation
can be a sign of poor performance.
6. Plummeting
stock prices: Stock prices are indicators of a
market value for the company. Instability and often decline in price may force
shareholders to pull out of the company by disposing shares. Creditors observe
performances of an organization based on the stock prices.
Options in Time
of Financial Distress
Business firms
can deal with financial distress, that is, when they are in a Z score of between
1 and 10, in several ways which may include:
1. Disposing of real property: A company may opt for this to get money to pay its creditors and meet
other operating costs.
2. Merging with other firms:
Mergers and alliances, such as that between Bamburi Cement and Athi River,
can put a distressed company back on good financial footing. This is more
critical in the case of unnecessary competition. In recent years the oil industry
has witnessed some merger and buyouts, for example BP and Shell and more recently
BP-Shell and Agip in Kenya.
3. Reducing capital spending
on research and development: This option may make
a firm 'survive' in the short-run. In the long run, research is critical in
the light of dynamic business environment.
4. Issuing new shares:
This depends on whether a company has exhausted its authorized share capital.
5. Negotiating
with creditors: An organization may negotiate
with creditors to extend the duration of debt servicing. This may involve
new negotiations on interest rates and paying period. A successful negotiation
may save a company from liquidation.
6. Liquidation:
A situation in which a firm is terminated as a going concern involves selling
its assets to salvage its value. The proceeds, net of transaction costs, are
distributed to creditors in order of established priority.
7. Lay offs: Reducing staff levels is an option adopted by some organizations.
Other firms are right sizing their labour force.
Conclusion
This paper discussed
the theoretical aspect of a financially distressed firm based on a cyclical
concept. The financial life cycle model represents an important contribution
as a framework for analyzing the process of decline among business firms.
Research is necessary to find out whether Kenyan firms conform with the financial
life cycle model. Altman's model as a measure is a critical input to companies
in Kenya. Firms can know ahead of time when they are 'sick' and when 'healthy'.
Research on financial distress can also be done to identify strategies appropriate
at different stages of distress as suggested by Altman's Z score levels.
It is also necessary
for stakeholders to have knowledge of the Z score. This will assist them in
making decisions pertaining to an organization. Fund lenders for example need
to assess the Z score measure before committing finances.
* The author is a lecturer
in the Department of Commerce at the Catholic University of Eastern Africa.
His specialisation and research interest is in Finance. Currently, he is among
the few qualified financial analysts in Kenya.
Correspondence
Mr Jonah Aiyabei
Lecturer, Department
of Commerce
Catholic University
of Eastern Africa
P O Box 62157
Nairobi, Kenya
Email: jkaiya@hotmail.com
References
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