FINANCIAL MANAGEMENT IN SICK UNITS

OUTLINE

• Definition of sickness

• Causes of sickness

• Symptoms of sickness

• Prediction of sickness

• Revival of a sick unit

• Turnaround stories

• Debt restructuring

DEFINITION OF SICKNESSThere are two ways of looking at insolvency. The stock-based insolvencyoccurs when the firm has a negative net worth implying that its assets are less than its debt. The flow-based insolvency occurs when the operating cash flows of the firm are not enough to meet its obligations.

The companies (Second Amendment) Act, 2002 defines a “Sick Company”

as one:

(a) Which has accumulated losses in any financial year equal to 50 percent or more of its average net worth during four years immediately preceding the financial year in question, or

(b) Which has failed to repay its debts within any three consecutive quarters on demand for repayment by its creditors.

An industrial unit may be regarded as sick if (i) it faces financialembarrassment (arising out of its inability to honour its obligations as and when they mature), and (ii) its viability is seriously threatened by adverse factors.

CAUSES OF SICKNESS

A firm remains healthy if it (i) operates in a reasonably

favourable environment, and (ii) has a fairly efficient

management. When these conditions are not satisfied, the

firm is likely to become sick. Hence sickness may be caused

by:

• Unfavourable external environment

• Managerial deficiencies

Unfavorable External environment

Shortage of key inputs like power and raw materials

Changes in government policiesDevelopment of new technologyShift in consumer preferencesSudden decline in the orders from the

governmentReduced lending by financial institutions

Managerial deficiencies

Production• Improper location• Wrong technology• Uneconomic plant size• Weak production and quality control

Managerial deficiencies

Finance• Wrong Capital Structure• Bad investment decisions• Weak budgetary control• Poor management of receivables• Bad cash planning and control• Strained relationship with the suppliers of capital

Managerial deficiencies

Personnel• Ineffective leadership• Bad labour relations• Over Staffing• Irrational compensation structure

Managerial Deficiencies

Marketing Inaccurate demand projection Improper product mixWrong product positioningPoor customer serviceHigh distribution costs

RBI STUDYA study conducted by the Reserve Bank of India, which covered 378 units, on the causes of industrial sickness revealed the following picture:

Cause Number Percentage

• Mismanagement and managerial deficiencies 197 52

• Faulty initial planning and other technical drawbacks 52 14

• Labour trouble 9 2

• Market recession 86 23

• Others (infrastructural factors, raw material shortage, etc.) 34 9

100 100

RBI STUDY

The RBI study summed up the thrust of its findings as follows:

“A broad generalisation regarding important causes of industrial sickness emerges. It is observed that the factor most often responsible for industrial sickness can be defined as 'management'. This may take the form of poor production management, poor labour management, poor resources management, lack of professionalism, dissensions within the management, or even dishonest management.”

SYMPTOMS OF SICKNESSSickness does not occur overnight, but develops gradually over time. A firm which is becoming sick shows symptoms which indicate that trouble lies ahead of it. Some of the common symptoms are:

• Delay or default in payment to suppliers.• Irregularity in the bank account.• Delay or default in payment to banks and financial institutions.• Non-submission of information to banks and financial institutions.• Frequent requests to banks and financial institutions for additional credit.• Decline in capacity utilisation.• Poor maintenance of plant and machinery.• Low turnover of assets.• Accumulation of inventories.• Inability to take trade discount.• Excessive turnover of personnel.• Extension of accounting period.• Resort to ‘creative accounting’ which seeks to present a better financial picture

than what it really is.• Decline in the price of equity shares and debentures.

PREDICTION OF SICKNESS

While the above symptoms suggest that the unit is in difficulty

and may become potentially sick, it is not easy to reach a

definitive conclusion about impending sickness on the basis of

these symptoms. Can sickness then be predicted more reliably

by some other means? Considerable amount of empirical

research done in the last two decades or so suggests that

financial ratios can be used for predicting industrial sickness

with greater reliability. This research, in general, involves two

types of analysis: univariate analysis and multivariate analysis.

UNIVARIATE ANALYSIS

• In univariate analysis, an attempt is made to predict

sickness on the basis of single financial ratios.

• In a path-breaking study W.H.Beaver compared the

financial ratios of a sample of 79 failed firms with 79

non-failed firms.

• His analysis suggested that many of the ratios employed

by him showed the power to signal an impending failure.

UNIVARIATE ANALYSIS

• L.C.Gupta considered a sample of 20 sick and 21 non-

sick companies to test the predictive power of 63 financial ratios.

• He employed the criterion of ‘percentage classification error’ to judge the predictive power of financial ratios

• He found that the two ratios of about equal merit were : (i) EBDIT/Sales, and (ii) OCF/Sales (EBDIT stands for earnings before depreciation interest and taxes. OCF stands for operating cash flow which is equal to profit after tax plus depreciation)

MULTIVARIATE ANALYSISMultivariate analysis, on the other hand, seeks to predict industrial sickness using a methodology that considers the combined influence of several variables (financial ratios in our context). The multivariate technique commonly used in predicting business failure or sickness is the technique of multiple discriminant analysis. This is a statistical technique which helps in classifying an observation into one of the several pre-specified groups (classes) on the basis of certain characteristics of the observation. It essentially involves estimating a function which discriminates best between the groups. The discriminant function is usually a linear one:

Z = a1X1 + a2X2 + … + anXn

where Z = discriminant indexXi = independent variable (i = 1, … , n)ai = coefficient of variable i (i = 1, … , n)

ALTMAN’S MODEL

EBIT Net working capital Z = 3.3 + 1.2 Total assets Total assets

Sales Market value of equity + 1.0 + 0.6 Total assets Book value of equity

Accumulated retained earnings + 1.4 Total assets

where Z is an index of bankruptcy 

A Z score less than 2.675 implies that the firm has a 95 percent chance of becoming bankrupt within one year. However, Altman’s analysis shows that the area between 1.81 and 2.99 may be regarded as a gray area. Thus Z 1.81 predicts bankruptcy and Z 2.99 nonbankruptcy.

ALTMAN’S REVISED MODELAltman’s original Z score model was developed for listed firms and manufacturing firms. He revised his model for unlisted firms and non-manufacturing firms. The revised model is:

Net working capital Accumulated retained earnings Z = 6.56 + 3.25 Total assets Total assets

EBIT Book value of equity + 1.05 + 6.72

Total assets Total liabilities

 According to his analysis: Z < 1.23 indicates a bankruptcy prediction 1.23 < Z < 2.90 indicates a gray area Z > 2.90 indicates no bankruptcy

AN INDIAN STUDYIn a very comprehensive study done with Indian data S.S.Srivastava and Y.A.Yadav1 developed a multiple discriminant analysis model for predicting industrial sickness. From a long list of 36 financial ratios, they selected the following four financial ratios:

V9 = earnings before interest and taxes/total tangible assets

V25 = current assets/current liabilitiesV31 = net sales/total tangible assetsV35 = defensive assets/total operating expenditure

The discriminant function which appeared to discriminate best between the sick and the non-sick companies was defined as:

Y = 19.8927V9 + 0.0047V25 + 0.7141V31 + 0.4860V35

The cut-off value of the discriminant score was determined as 1.425.

1 S.S.Srivastava and R.A.Yadav, Management and Monitoring of Industrial Sickness, New Delhi : Concept Publishing Company, 1986.

A CRITIQUE OF BANKRUPTCY

PREDICTION MODELS

Though various bankruptcy prediction models appear to possess some predictive value, it is very difficult to generalise about corporate failure for the following reasons:

• We do not have a well-defined theory of corporate failure to guide empirical work.

• Empirical studies are statistically flawed because they are

retrospective in nature.

Notwithstanding the above criticisms, well-specified multivariate models provide timely warning.

VIABILITY STUDY

A viability study covers the following:

• Market analysis

• Production/technical analysis

• Finance

• Personnel

• Environment

REVIVAL PROGRAMME

The revival programme may involve the following

• Settlement with creditors• Provision of additional capital• Divestment and disposal• Reformulation of product market strategy• Modernisation of plant and machinery• Reduction in manpower• Strict control over costs• Streamlining of operations• Improvement in managerial systems• Workers’ participation• Change of management

DEBT RESTRUCTURING

The common elements of debt restructuring schemes are:

• Interest rate relief

• Deferment of past interest dues

• Waiver of penalties

• Reschedulement of loan repayment

• Reduction in loan amount

TAX PROVISIONS APPLICABLE TO DEBT RESTRUCTURING

The following tax provisions are applicable to debt restructuring.

1. Interest and other charges payable on all borrowings from financial institutions and on term loans from banks are tax-deductible only if the same has been paid in the previous year. This means that interest overdue is not a tax-deductible expense. Hence, in a subsequent year when overdue interest is remitted on waived as part of debt restructuring, there will be no tax implication.

2. Interest on working capital facilities such as cash credit and overdraft is tax-deductible on an accrual basis, regardless of when it is paid. Hence, if such interest is subsequently remitted or waived as part of debt restructuring, it would be deemed as income of the relevant previous year and subjected to tax.

3. Waiver, partial or total, or principal amount, as a result of debt restructuring, has no tax implication for the borrower. Such a capital gain is not taxable under Section 45 of the Income Tax Act, as there is no transfer of a capital asset within the meaning of that section.

ACCOUNTING TREATMENT OF DEBT

RESTRUCTURING

For purposes of, accounting companies have to follow the mercantile system of accounting and hence have to charge interest to the profit and loss account on an accrual basis. Hence, if interest is waived as part of debt restructuring, it is written back to the profit and loss account as a revenue profit.

If principal repayment is waived, as part of debt restructuring, it is treated as remission of capital liability. Hence it is treated as a capital profit and credited to capital reserve. The credit may be made through the profit and loss appropriation account, supported by a note explaining the credit.

DEBT RESTRUCTURING – THE ARVIND MILLS CASE

Arvind Mills Limited, the Ahmedabad-based denim manufacturer built a huge capacity during 1987-1997, substantially financed with debt, comprising of domestic loans and eurocurrency bonds. The sharp decline in denim prices in 1998-1999 combined with a steep rise in the price of naptha, the feedstock for Arvind’s captive power plant caused financial distress. Arvind could not service its 85 domestic and international lenders who had a cumulative exposure of a staggering Rs. 2700 crore.

Jarding Fleming Singapore Securities one of the lenders, headed the steering committee of lenders that drew up a debt restructuring plan, which was based on the ‘Market Study and Due Diligence of Business Plan of Arvind’ prepared by KSA Technopark. On the basis of future cash flow assessment, the plan provided for a write off of 40 percent of Arvind’s debt commitment. Three banks dissented with this plan and petitioned before Gujarat High Court for Foreclosure. The court, however, dismissed the petition and directed the dissenting banks to agree to the plan proposed by steering committee. Finally, 40 percent of the debt was waived off and the repayment of the balance 60 percent was staggered with a reduction in the interest rate.

TURNAROUND STORIES

A number of sick companies have been turned around with the help of intelligently crafted strategies, dynamic leadership, expedient initiatives, and sustained efforts. Here are some examples:

• E.I.D. Parry

• Andhra Pradesh Paper Mills

• TVS Suzuki

COMMON ELEMENTS IN TURNAROUNDS

According to Pradip Khandwalla, the key elements found commonly in turnarounds are:

• A change in the top management

• A substantial involvement of top management in the day-to-day operations.

• An emphasis on projects that have a quick payoff

• Opportunistic action, improvisation, crisis management, and short-term expediency.

SUMMING UP

• A sick unit faces financial embarassment and its viability is seriously threatened by adverse factors.

• A study of RBI observed that the factor most responsible for industrial sickness can be defined as ‘management’.

• Financial ratios can be used for predicting sickness.

• When an industrial unit is identified as sick, a viability study is conducted which covers the following aspects : market, production, finance, personnel, and environment.

• A revival plan may cover, inter alia, settlement with creditors, reformulation of product-market strategy, strict control over cost, and change of management.