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Chapter 16
FINANCIALLY TROUBLED VENTURES:
TURNAROUND OPPORTUNITIES?
FOCUS
We direct attention in this chapter toward recognizing and managing financial distress.
An inability to pay creditor obligations as they come due typically poses a major financial
threat and certainly distracts the venture from its primary mission. A successful
entrepreneur copes with such financial distress and finds a way to turn the situation
around. The alternative to a successful turnaround is venture liquidation.
LEARNING OBJECTIVES
1. Explain financial distress faced by troubled ventures.
2. Define and describe insolvency.
3. Describe how troubled ventures emerge from financial distress.
4. Describe how private reorganizations and liquidations take place.
5. Describe reorganization under Chapter 11 of the U.S. bankruptcy laws.
6. Describe liquidation under Chapter 7 of the U.S. bankruptcy laws.
CHAPTER OUTLINE
16.1 VENTURE OPERATING AND FINANCING OVERVIEW
16.2 THE TROUBLED VENTURE AND FINANCIAL DISTRESS
A. Balance Sheet Insolvency
B. Cash Flow Insolvency
C. Temporary Versus Permanent Cash Flow Problems
16.3 RESOLVING FINANCIAL DISTRESS SITUATIONS
A. Operations Restructuring
B. Asset Restructuring
C. Financial Restructuring
16.4 PRIVATE WORKOUTS AND LIQUIDATIONS
A. Private Workouts
B. Private Liquidations
C. Venture Example: Jeremy’s Microbatch Ice Creams, Inc.
16.5 FEDERAL BANKRUPTCY LAW
A. Bankruptcy Reorganizations
B. Reasons for Legal Reorganizations
C. Legal Reorganization Process
D. Bankruptcy Liquidations
SUMMARY
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DISCUSSION QUESTIONS AND ANSWERS
1. What are the three types or methods of restructuring available when trying to turn
around financially troubled ventures?
2. Identify major factors that cause ventures to get into financial trouble.
Ventures get into trouble by mishandling strategic issues, failing to unite management
on key initiatives, and having poor finance and accounting practices and controls.
3. What is meant by financial distress?
4. What is meant by loan default? Also, describe (a) an acceleration provision and (b) a
cross-default provision.
A loan default is when there is a failure to meet interest or principal payments when
5. What is foreclosure?
Foreclosure is a legal process used by creditors to try to collect amounts owed on
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6. What do we mean when we say a venture is insolvent?
7. Compare and contrast (a) balance sheet insolvency and (b) cash flow insolvency.
Balance sheet insolvency is when the firm has negative equity (or the debt is greater
8. Use the concept of cash flow insolvency over time and describe what would happen if
the problem is temporary rather than permanent.
9. What are some of the basic requirements of a successful turnaround plan?
A successful turnaround plan should provide immediate remedial actions (once
serious financial problems are recognized) and detail the financial ramifications
10. Define operations restructuring and describe how it can be implemented to escape
financial distress.
11. Define asset restructuring and describe how it can be implemented to escape from
financial distress.
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12. Define financial restructuring and describe what is meant by debt payments extension
and debt composition change.
Financial restructuring involves changing the contractual terms or composition of the
13. What is a private workout? Also, describe some of the characteristics of ventures
that are likely to engage in private workouts.
A private workout is a voluntary restructuring of the firm in lieu of declaring
14. What is a private liquidation? What does the process of assignment mean?
15. What is Chapter 11 bankruptcy and how is it used by ventures?
16. Describe a venture bankruptcy. Also, indicate the difference between (a) a voluntary
bankruptcy petition and (b) an involuntary bankruptcy petition.
17. Briefly describe the common pool and holdout problems that often make it necessary
for a venture to enter into a court-supervised reorganization.
A common pool problem exists because individual creditors have an incentive to
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18. Briefly define the following terms: cram down procedure, debtor-in-possession
financing, and prepackaged bankruptcy.
A cram down procedure is when a bankruptcy court accepts a reorganization plan for
19. Describe the absolute priority rule.
20. What is the purpose of Chapter 7 of the U.S. Bankruptcy Code? What are some of the
characteristics of ventures that use Chapter 7 instead of private liquidation?
21. From the Headlines – Necton: Describe the business model turnaround Necton
undertook. Comment on what you think would have been the challenges and your
perceptions about the likelihood the new business model will succeed.
Answers will vary: While the market for Necton’s products appears promising, the
INERNET ACTIVITIES
1. Go to the Web site for Wall Street Journal or some other financial publication such
as Inc. magazine and identify a venture that has recently filed for reorganization or
liquidation with the U.S. bankruptcy courts. Then, access the Securities and
Exchange Commission’s Web site at
http://www.sec.gov/edgar/searchedgar/webusers.htm and find recent financial
statements for the venture you identified as being in financial distress. By way of a
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hint, you will probably want to access the most recent Form 10Q which provides
quarterly information. Determine whether the venture was suffering from balance
sheet insolvency, cash flow insolvency, or both. Explain the bases for your insolvency
assessments.
Web-research results will vary due to constant updated of the related web sites.
EXERCISES/PROBLEMS AND ANSWERS
1. [Balance Sheet Restructuring Concepts] It was shown earlier in the chapter that
Northland Industries was suffering from balance sheet insolvency. Two scenarios are
possible for Northland in year 3. In scenario 1, year 3 for Northland is expected to
result in an additional $150,000 operating loss. On the other hand, scenario 2 is
expected to be a “breakout” year for Northland where higher sales and lower costs
due to economies of scale are forecasted to produce operating profits of $250,000 in
year 3. Total assets are expected to remain at $200,000 under either scenario. Total
debt will be increased to finance additional operating losses. On the other hand,
operating profits will be used to reduce total debt.
A. Show Northland’s basic balance sheets under both scenarios.
Year 0 Year 1 Year 2 Scenario 1 Scenario 2
Current Assets 100,000 100,000 100,000 100,000 100,000
Fixed Assets 100,000 100,000 100,000 100,000 100,000
Total Assets 200,000 200,000 200,000 200,000 200,000
Total Debt $0 $100,000 $250,000 $400,000 $0
Equity:
Common Stock 200,000 200,000 200,000 200,000 200,000
Retained Earnings 0 -100,000 -250,000 -400,000 0
Total Equity 200,000 100,000 -50,000 -200,000 200,000
Total Debt & Equity
$200,000 $200,000 $200,000 $200,000 $200,000
YEAR 3
B. Based on your analysis, will Northland Industries still be balance sheet insolvent
in year 3 under scenario 1? If this trend continues, would you describe
Northland’s financial distress as a temporary or permanent problem?
C. Based on your analysis, will Northland Industries still be balance sheet insolvent
in year 3 under scenario 2? If this trend continues, would you describe
Northland’s financial distress as a temporary or permanent problem?
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4. [Turnaround Opportunity: Restructuring Issues] Following are the financial
statements for the Chenhai Manufacturing Corporation for 2015 and 2016. The
venture is in financial distress and hopes to turn around its financial performance in
the near future.
CHENHAI MANUFACTURING CORPORATION
2015 2016
Cash $ 50,000 $ 10,000
Accounts receivables 200,000 250,000
Accounts payable $ 130,000 $ 170,000
Accruals 50,000 70,000
Bank loan 90,000 90,000
Total current liabilities 270,000 330,000
2015 2016
Net sales $ 1,400,000 $ 1,000,000
Cost of goods sold -780,000 -700,000
Gross profit 620,000 300,000
*Note a tax credit would be generated and could be used if the firm returns to
profitability in the future.
A. Calculate the sale-to-cash conversion period for Chenhai in both 2015 and 2016.
Refer to Chapter 6 for calculating the cash conversion cycle and its three
components. Note: use “yearend” balance sheet data instead of averages so that
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2016.
Note: the inventory-to-sale conversion period also is referred to as the inventory
and 2016. Also determine the length of the cash conversion cycle for both 2015
and 2016.
The purchase-to–payment conversion period is the third component in the cash
conversion cycle.
D. What type of working capital restructuring might Chenhai undertake to turn
around its financial performance? What other type of asset restructuring might
Chenhai consider undertaking?
The CCC has increased from 178.49 days to 221.61 days. An effort should be
E. What type(s) of operations restructuring might Chenhai attempt during 2017?
F. What type(s) of financial restructuring might Chenhai attempt during 2017?
Chenhai might attempt to reduce the amount of long-term debt that is outstanding
G. What prevailing conditions (economic, competitive, etc.) might cause you to
believe that Chenhai’s situation may be a turnaround opportunity versus a
permanent problem?
Of major concern is the decline in sales from $1,400,000 to $1,000,000. If the
5. [Financial Restructuring Issues] EnCal is a small West Coast-based power company
specializing in power generation methods that use clean burning fuels and renewable
natural resources. However, due to complex and confusing power pricing structure,
EnCal is reeling from the aftereffects of the state government’s attempt at power
deregulation. EnCal has been unable to pass its operating costs on to its consumers.
To make matters worse, EnCal has recently completed construction on several power
production centers in efforts to double its capacity and to help diminish the frequency
of power outages that are wreaking havoc on local commerce. As a result, they have
accumulated a massive debt load to help finance these facilities and are on the verge
of default. However, raising the prices of the power it supplies to its consumers
involves a slow and laborious bureaucratic process and regulatory approval. EnCal
is forced to reorganize its financing. EnCal’s partial income statements and balance
sheets for the 2015 and 2016 fiscal years follow. An incomplete income statement for
2017 is also provided.
A financial restructuring that would reduce EnCal’s debt burden has been
proposed. The proposal is to reduce the interest rate on its bank loan to 6% and loan
principal to $100 million, to reduce the interest rate on its mortgage loans to 8%, and
to replace all of its subordinated loan balance with a 50% equity stake in the
company.
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Income Statement ($ Millions)
2015
2016
2017
Revenue
$240
$360
?
COGS (70% – 2015, 80% – 2016/2017)
–168
–288
?
Gross Profit
72
72
?
SG&A
–30
–35
–35
EBITDA
42
37
?
Depreciation
–20
–30
–40
EBIT
22
7
?
Interest
–22
–92
?
Earnings Before Taxes
0
–85
?
Taxes (40%)
0
0
?
Net Income
$0
–$85
?
Balance Sheet ($ Millions)
Assets
Cash
$10
$10
Accounts Receivable
20
30
Inventories
10
15
Fixed Assets, Net
510
1,080
Total Assets
$550
$1,135
Liabilities and Equity
Accounts Payable
$14
$24
Notes Payable (8% Bank Loan)
50
140
Accrued Liabilities (Wages & Taxes)
4
4
Long-Term Mortgage Loans (10%)
180
460
Long-Term Subordinated Loans (12%)
0
290
Common Stock
300
300
Retained Earnings
2
–83
Total Liabilities & Equity
$550
$1,135
A. Assuming a 25% increase in revenue with no additional capital investment, what
will EnCal’s new income statement and balance sheet look like in the business as
usual and financial restructuring scenarios?
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EnCal Corporation 2017 2017 Re–
Income Statement ($ Millions) 2015 2016 BAU structure
Revenue $240 $360 $450 $450
COGS (70% – 2015, 80% – 2016 & 2017) –168 –288 –360 –360
Gross Profit 72 72 90 90
SG&A –30 –35 -35 -35
EBITDA 42 37 55 55
Depreciation –20 –30 -40 -40
EBIT 22 715 15
Interest –22 –92 –92 -43
Earnings Before Extraordinary Item 0 -85 -77 -28
Debt Foregiveness in Restructure 40
Earnings Before Taxes 0 -85 -77 12
Liabilities
Accounts Payable $14 $24 $30 $30
Notes Payable (8% to 6% Bank Loan) 50 140 140 100
Accrued Liabilities (Wages & Taxes) 4 4 4 4
Retained Earnings 2 –83 –160 –71
Total Liabilities & Equity $550 $1,135 $1,064 $1,113
Note: Interest Calculations
Notes Payable (Bank Loan) 8% to 6% 11 6
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B. Will EnCal be able to service its debt under either scenario?
Under the restructured 2017 projection they can service the debt. Under the
C. Would EnCal be a likely candidate for Chapter 7 bankruptcy?
D. Suppose the governor has called an emergency legislative session on the utility’s
behalf to prevent its eventual bankruptcy. If the governor is able to get a bill
passed supporting a rate hike on electrical power, how much must the EnCal
charge per kilowatt if it is going to be able to cover its interest payments under
the new financial restructuring plan. Assume EnCal’s power generation facilities
have a maximum capacity of 800 megawatts with an average capacity utilization
of 50%.
MINI CASE: ENDCO, INC.
Endco is a wireless solutions provider that facilitates wireless Internet access through
small remote devices that connect to portable computers. During the past several years,
Endco was lavished with an abundance of equity financial capital from a variety of
venture investors. Although initial adoption rates for this new service were far below
expectations, most were confident that expanding the service area and thus increasing the
service’s availability to new and existing users would result in rapid increases in the
volume of new subscribers. Helping to fund this massive expansion, Endco arranged
tremendous amounts of debt financing, much of which was secured by the expansion
assets themselves (i.e. wireless towers and transmission facilities). However, recently it
became clear that Endco would not be profitable and would only continue to burn large
amounts of cash if it continued to operate. Using the financial data provided, answer the
following questions regarding Endco’s Chapter 7 bankruptcy liquidation.
Administrative and legal fees are $370,000, and the bank underwriting the notes
payable have the “right of offset” on cash deposits, the amount indicated in the cash
account on the balance sheet.
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Balance Sheet ($ Millions)
Assets
Liquidation
Receipts
Cash
$2.4
$2.4
Inventory
16.0
5.0
Accounts Receivable
5.6
3.0
Net Plant
200.0
165.0
Net Equipment
100.0
57.0
Total Assets
$324.0
$232.4
Liabilities & Equity
Accounts Payable
$3.5
Notes Payable (12% Bank Loan)
29.0
Accrued Liabilities (Wages & Taxes)
1.5
Long-Term Mortgage Loans (12%, 10 years)
140.0
Long-Term Subordinated Loans (14%, 15 years)
80.0
Debentures (Subordinated to Notes Payable)
20.0
Preferred Stock
300.0
Common Stock
100.0
Retained Earnings
–350.0
Total Liabilities
$324.0
A. Who are considered to be the priority claimants in this liquidation?
The priority claimants are the government, employees and mortgage holders.
B. Who are considered to be general creditors?
C. Create a table indicating the cash distribution to each creditor and the percentage of
the original liability that is satisfied.
Claimant
Priority
Payments
Remaining
Claims
Payments on
Remaining Claims
Total
% Liability
Satisfied
Administrative and Legal
0.37 0.37
Wages & Taxes 1.50 1.50 100.00%
Long-Term Mortgage Loan 140.00 140.00 100.00%
Long-Term Subordinated Loan 0.00 80.00 64.04 64.04 80.05%
Accounts Payable $3.5 2.80 2.80 80.05%
Notes Payable 2.40 26.60 21.29 23.69 81.70%
Debentures 20.00 0.00 0.00 0.00%
Totals $144.27 $130.10 $88.13
Excluding Debentures $110.10
Remaining balance $88.13
Pay rate to general creditors 80.05%