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Understanding the Bankruptcy Process
Finance Textbooks Boundless Finance Capital Structure Understanding the Bankruptcy Process
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Concept Version 6
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Financial Management Before and During Bankruptcy

To avoid the negative impacts of bankruptcy, individuals and companies in financial distress can implement certain financial management techniques.

Learning Objective

  • Devise a management plan when a company is in financial distress


Key Points

    • Bankruptcy has the disadvantage of making it more difficult for an individual to borrow in the future, and companies that are reorganized and not dissolved face the risk of higher costs of capital for future operations.
    • Before entering into bankruptcy, a company or individual can reduce debt obligations and take actions to increase income and profitability.
    • During the period of reorganization, a company must reduce debt and increase profits in order to emerge from bankruptcy without losing control of operations.

Term

  • garnishment

    A judgment that a third party should pay money owed to a debtor directly to a creditor.


Full Text

Management before and during Bankruptcy

Financial Management before and during Bankruptcy is an effective method for companies and individuals to remedy financial distress and insolvency. However, it has the disadvantage of making it more difficult for an individual to borrow in the future and companies that are reorganized and not dissolved face the risk of higher costs of capital for future operations after emerging from bankruptcy. To avoid the negative impacts of bankruptcy, individuals and companies in financial distress have a number of bankruptcy alternatives.

Management before Bankruptcy

Financial distress typically arises when a high amount of fixed or unavoidable costs exists relative to the amount of cash flow or income. In terms of an individual, the most obvious solution is to reduce monthly spending to allow extra cash flow to service debt. For a company, there are many options of avoiding financial distress, including:

  • decrease the amount of financial and operating leverage,
  • dispose of investments or operations not producing a profit,
  • stagger or extending obligatory payments on debt,
  • lower earnings distributions, such as dividends,
  • diversify operations,
  • reduce costs where possible,
  • avoid risky investments,
  • improve efficiency.

If the situation is too dire for such measures and a debtor does not expect to have steady income or property, it may be appropriate to utilize the take no action approach. In other words, the debtor should do nothing since a company with no assets or income cannot undergo garnishment by a creditor. In such cases, however, a creditor could attempt to seize.

Altman Z-Score

A company may reference the Altman Z-score formula in order to determine the likelihood that it will be forced into bankruptcy. The formula may be used to predict the probability that a firm will go into bankruptcy within two years. The Z-score uses multiple corporate income and balance sheet values to measure the financial health of a company. Specifically, the formula references:

  • ratios of working capital to total assets,
  • retained earnings to total assets,
  • EBIT to total assets,
  • market value of equity to book value of liabilities,
  • sales to total assets .

Management during Bankruptcy

For the option of financial management during bankruptcy to exist, a form of bankruptcy allowing reorganization, such as chapter 11, must be used. Chapter 11 requires that all interested parties agree on a plan. Once confirmed, the plan becomes binding and identifies the treatment of debts and operations of the business for the duration of the plan. Under this plan, a debtor may be able to acquire financing and loans on favorable terms by giving new lenders first priority on the business' earnings. The court may also permit debtors to reject and cancel contracts previously agreed to, if this would be financially favorable to the company and its creditors. If the company's debts exceed its assets, the bankruptcy can result in the company's owners being left with nothing. In such a case, the company's creditors may be awarded with ownership of the newly reorganized company. During the period of reorganization, a company must utilize financial management, consisting of the options listed above, in order to emerge from bankruptcy without losing control of operations.

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