Financial insolvency

What is insolvency

When a company or person can’t pay back their debts as they fall due

What is financial distress

The stages before and including insolvency

Types of insolvency and explain

• Cash flow/flow based insolvency

  • when a firm doesn’t have enough cash to meet its contractually obligated commitments

    • essentially cash rich, house poor

    • common in young firms or firms waiting on AR

• Balance sheet insolvency

  • when the value of a firms assets is less than the value of debt.

    • essentially cash poor and house poor

    • Equity no longer exists since equityholders are residual claimants so they get wiped out the second debt=assets

How is equity similar to a call option

Type of option: call option

underlying asset: the value of the firm

strike price: value of debt

premium: equity value/stock price

hence shares in a firm with financial distress are still considered valuable because volatility increases the chance of it being in the money

Distortions arising from financial distress

1. asset substitution

• tendancy for managers to pursue excessive risk-taking investments because the upside to shareholders is unlimited but their downside is limited

• hence in the example, even though the more certain option increases firm value, equityholders still prefer the risky one since it increases their expected return.

2. Debt overhang/underinvestment

• incentive for managers to underinvest in good projects because most of the benefit goes to creditors/lenders.

Options when firm is in financial distress

liquidation(if the firm is worth more dead to debtholders) or reorganisation(if the firm is worth more alive to debtholders)

Reogranisation

• keep the firm operating just restructure the claims

  • ie. such as issuing new securities to replace old ones, or selling assets to raise cash, engiotating with creditors to reduce debt or issuing new equity in a new company

• if things are too bad, the firm goes into voluntary administration

  • this is when independent registered liquidator who takes control of the company and they decide if company should be saved or liquidated

    • this gives time for third parties or management to see if they can save the company

  • Voluntary administrator proposes a DOCA which is a binding agreement between the company and creditors regarding how the company will be handled and how much creditors will be paid

  • If creditors approve DOCA, company is saved, if not it gets liquidated

Liquidation

assets are sold for salvage and the proceeds go to paying creditors in order of priority

• Liquidation costs:

  • Paying lawyers, pay liquidator fees 

• Secured creditors: paying creditors with secured assets (where the debt is guaranteed by some asset, ie. if you borrowed money for a company car, if you didn’t pay them back they would just take the car)

• Employee entitlements: super, wages

• Unsecured creditors: suppliers, customers (in order of seniority) 

• Shareholders

Z-score critera:

• is less than <1.81: high prob of insolvency

• if more than >3, low prob of insolvency