Financial Diagnosis of Distressed Companies

Available online at www.sciencedirect.com Procedia Economics and Finance 3 (2012) 1134 – 1140 Emerging Markets Queries in Finance and Business Financial diagnosis of distressed companies Ioan Birceaa,* a Nicolae Iorga street, no. 1, 540 080, Romania Abstract Against the background of the economic crisis and of a fierce competition, the external and internal environment becomes more and more hostile and as such, many commercial societies, can record financial disturbances or even bankruptcy. On the basis of symptoms, the level of some economic-financial indicators, following a proper diagnosis, one can apply a therapy that can improve the situation or fully restore the company. The study conducted by the author on a guided sample of trading companies from Romania, aimed at developing a model of financial diagnosis, which can reflect quickly, based on the level of a score, the economic financial situation, the performance, the present and future risks, as a result of the policies and decisions taken. 2012 Published Published Elsevier Ltd access Selection peer-review under responsibility of the © 2012 The© Authors. by by Elsevier Ltd. Open underand CC BY-NC-ND license. Selection and peer review under responsibility Emerging Markets Queries in Finance and Business local organization. Markets Queries in Finance of and Business local organization Emerging Keywords: diagnosis; economic indicators; risks; evaluation grid; 1. Introduction In this period, marked by political, social, economic convulsions that Romania passes through, administering a company under these circumstances is an act of big commitment, courage and liability risk. The manager, the creditors, the owners, the employees, etc. depending on their interests, want to know at all times the performance and the risks to which the trading company is subjected. In particular, the manager wants to know the causes that can generate financial slippages and, informed, to be able to take those financial decisions in order to avoid them. To that effect, a useful tool, or a method of research, to be used by all those interested is the diagnosis of the trading company. The interest in the financial diagnosis of a company was * Corresponding author. Tel.: +40 745 644 004 E-mail address:[email protected]. 2212-6716 © 2012 The Authors. Published by Elsevier Ltd. Open access under CC BY-NC-ND license. Selection and peer review under responsibility of Emerging Markets Queries in Finance and Business local organization. doi:10.1016/S2212-5671(12)00286-9 1135 Ioan Bircea / Procedia Economics and Finance 3 (2012) 1134 – 1140 manifested early, proof being the models developed so far, models developed by banks, financial consultancy companies, various specialists. In most of the cases the diagnosis of the trading companies is acclaimed only when the company is in financial difficulty; however, companies with a responsible management uses this tool continuously, even when their financial performance is high. Ignoring the signals given by the financial diagnosis can cause the degradation of the economic-financial condition of the trading company and its entering into insolvency proceedings, mathematically the insolvency can be shown by the following inequality: available funds at the due date < due and liquid, certain debts. The failure to pay these debts at the due date will generate pressures from those who should collect them, having chronic implications in the economic-financial situation. Having in mind the issues presented and the changes in the balance sheet, we can establish on the basis of the equation 1, the factors and their influence. C ( SE FL ) FA NWC SC NP PA R FL FA NWC (1) Where: C- Cash and bank accounts +short term investments, SE- shareholders equity, LF SC-Share capital; NP Net profit, R-Reserves, PA-profit appropriation, FA- Fixed assets, FL financial liabilities, credit bank and related interests+ bonds and related interest, NWC- Working capital need. The lack of financial performance NP, an improper policy of distribution of dividends, retained earnings, major investments in relation to financial , an ineffectual policy of , are causes that determine the level of these indicators, with negative consequences on the availability of funds bank accounts and on the economic and financial situation on its whole. Thus, we can appreciate that the changes the Treasury and other patrimonial elements are the result of the management operations, reflected through the profit and loss account, as well as of the capital operations, investments, lending, reimbursement with effects reflected through the changes in the balance sheet. 2. Method The author's attention was directed toward a general diagnosis component namely to financial diagnosis. First, because financial performance, financial position, cash flows are a consequence of effective human resources management, technical and available funds management, or good commercial relations with customers, market share, and suppliers etc. Secondly, for an external analyst financial information can be known more easily, by the fact that the annual financial statements are mandatory and are published by all entities in Romania OMFP 1752\/2005. The method used in the study conducted, is a deterministic one, based on a scoring result. The financial diagnosis presented focused on those financial indicators, which express synthetically the diagnosis of profitability, economic, financial, and the diagnosis of risk, operational, financial, bankruptcy. The risk of bankruptcy is analysed both in a static manner through financial balances, balance sheet as well as through dynamic flows, the funding, the Treasury boards. 3. Results The score is obtained on the basis of 9 indicators selected by the author from a group of several indicators. One can appreciate that between certain indicators there is a determinist link, as demonstrated by the values of the multiple correlation coefficient. But the need for a more detailed analysis of return, risk and liquidity and an easier interpretation of the score obtained, justifies the use of these indicators. The study conducted involved taking several rounds. The first stage of the study implied a retrospective and present economic-financial analysis on a sample composed of 30 companies that were under the following circumstances: financial difficulty; having a normal economic and financial situation; or having a very good economic and financial situation. After the process of analysis the main causes that generated these situations were outlined. 1136 Ioan Bircea / Procedia Economics and Finance 3 (2012) 1134 – 1140 The second phase of the study implied the selection, made by the author, of some indicators considered to be representative to highlight the financial performance, the financial balances, the payment capacity, the risks etc. The arguments that formed the basis for the selection of these indicators were: As first argument, the causes which determine the financial imbalances and possibly the bankruptcy; Thus, from the point of view of: Leadership, a performing management, requires an appropriate sales policy, a rigorous cost control, a continuous investment and innovation policy, ensuring financial equilibria, an optimal financing structure based on costs, etc., generates a salary and a satisfaction measurement; Shareholders, increasing their wealth profit reinvest and being given a compensation dividends in accordance with the risks undertaken constitute elements of satisfaction for them; Creditors, the existence of a performance to ensure the possibility of repayment of the borrowed sums and the assurance that the assets of the company shall cover the debts are a way for further cooperation; Employees, a high added value supposes the possibility of earning substantial gains by them; Vendors and customers, in the case of compliance with the time limits provided for in the contract and quality products ensure a long-term collaboration. The financial diagnosis cannot be conceived outside the correlation analysis return on liquidity risk. All the activity undertaken in a trading company is under the aegis of efficiency, as a mandatory condition for maintaining itself on a competitive market. The breakeven rates, contained in the model, quantify the effectiveness of the activity through effective use of the resources involved. The first installment indicates us the profitability of the resources involved in operation, production and commercial, calculated as the ratio between the operating result EBIT and the invested capital, operating assets. It can be assimilated with the internal rate of return of the tradin this rate, gives us information concerning the price policy, the quality of the products, etc., as well as the cost management. The imposed lower limit, is laid down on the idea that the economic profitability will be superior to the average interest rate on credits reached, thereby confirming that the borrowed resources have a degree of efficiency enough to cover the cost of debt and, in addition to achieve a raised profitability. The disadvantage of the calculation of this rate with increase in operating profit, on, is that it can be manipulated through the depreciation policy and adjustment of the firm. I accepted this thing, as we need information on the depreciation policy practiced. A high operating profit supposes in mathematical terms a maximization of the revenues in relation to the costs of exploitation. The second rate, the financial profitability rate ROE, is taken in the study even though it is dependent on the economic profitability, taking into account the interest manifested by those who have invested their money. Through the net profit NP this rate is affected by the financial policy, the fiscal policy and the extraordinary result. It is recommended that it should be superior to the average profitability on the market of the shares traded, to convey a positive signal to potential investors and to determine a course of high quotation. A particular position on the financial market, stock market, credit market, etc., is determined not only by the financial performance but also by the risks related to this company. Following the studies carried out, the financial analysts have concluded that, in essence, there are two categories of variables which cause the greatest sensitivity of the results indicators, cost structure and financial structure of the enterprise Mironiuc, 2006. An inadequate structure of costs, fixed costs in relation to variable costs, will cause a major global risk. Both the risk of exploitation and the financial risk in this particular diagnosis are quantified by the ratio index, Safety, between the turnover, Sales, and the turnover calculated break-even, Break-even sales. A value under 1.1 of this report is appreciated as a major global risk. Decisions on sales volume, fixed and variable costs level, sales structure, the introduction of a new technology, the modernization of the equipments, etc., are taken, in most of the performing societies, following the costvolume-profit analysis. In the absence of financial performance NP, financing the investments and the management activity, the existence if not also the growth of the trading company, involves appealing to 1137 Ioan Bircea / Procedia Economics and Finance 3 (2012) 1134 – 1140 borrowed sources , will determine the cost increase by interest, which also implies a more pronounced decrease of the profit and an increase of the financial risk. According to the studies carried out, a degree of indebtedness of more than 70%, causes, besides the financial autonomy decrease, an increase of the risk of insolvency. For the amounts borrowed, the creditors, due to the prudence manifested, appreciate the possibility of their recovery in liquidity arising from the sale of the economic assets held. Thus, for the obligations that reached maturity in the short term, it is checked whether they are covered by the current assets, and for the total obligations it is checked if they are covered to a certain proportion from the total assets held. An optimal financial structure preoccupies both the trading company managers, the cost of the sources, and the investors and lenders return-risk to the same extent. The financing decision is an attribute of the management and it is based essentially on the cost of financing. The cost of the own sources is, as I have presented, the opportunity cost and the cost of debt the interest is. The net cash flows remaining after the actually serve to the remuneration of the creditors and shareholders. However, the creditors have priority, being remunerated by interest. The shareholders in accordance with the criterion of the rest are remunerated from the net profit. On the basis of the IRR criterion, the capital investment is cost effective if IRR> interest rate; if this inequality is observed, through the cash flows arising from the operating, in time, the remuneration of the investors occurs at their level of exigency regarding the profitability. The decisions concerning the investments, the operation, their financing have direct effects on the financial balance A coherent policy on investments and their financing, long-term financial equilibrium, involves covering the investments from permanent resources. Through these measures, the company has a safety margin WC, contributing where appropriate to the financial equilibrium in the short term. The management activity is mostly financed from attracted resources suppliers, employees, shareholders, etc. If this resource is not sufficient, working capital is needed NWC. Even if the company has a high profitability, this does not imply the existence of liquidity, a phenomenon explained by the gap between the recording income and expenditure in accounting and their collecting or payment, i.e. the existence of some income or non-monetary expenses 2005. According to the theory of the financial balance, the net Treasury NT is the result of the difference between the Revolving Fund and the need for working capital fund: NT SE Long termdebs FA NWC WC NWC (2) In the case of a deficient balance of the Treasury, the first measures should aim at advancing some receipts and delaying the payment of some payments, not calling in credits, short term credit banks. A coherent policy on the management of clients and suppliers requires a negotiation of the collection and payment terms, so that the collecting should advance the payments. The efficient management of the current assets, high speed of turnover, represents a guarantee of the short-term financial balance and a growth of the profitability. The financial imbalance and the low liquidity are highlighted by the static diagnosis, an x-ray of the moment, and explained by the agency of the dynamic diagnosis. The dynamic analysis is based on the funds flows resulting from the management and capital operations. When to the insufficient profitability a negative cash flow resulting from the indispensable investment or from the redemption of debts previously contracted is added, the company will face chronic financial jam Mironiuc, 2006. Directly, the annual investment and the proportion of their funding from own sources, auto-financing, remaining after the payment of the dividends, are reflected by the rate of self-supporting. Self-financing is wealth created in society and left in its control, source with a lower cost than the average cost, and is considered in certain situations, the most efficient solution to cover the permanent needs and to ensure the financial independence. Unfortunately, it is insufficient in most of the cases. If the annual repayments to the lenders for the previously contracted amounts are not covered by the cash flows resulting from the management E-IP, but from the contracting of new loans in the future, the economic and financial situation will aggravate in the future. The pointer contained in the model and which, through its level, reflects the coverage rate of the loan repayment and interest RLR+I on medium or long term is the rate of 1138 Ioan Bircea / Procedia Economics and Finance 3 (2012) 1134 – 1140 repayment of the debts that are overdue. In the third stage, keeping the indicators, the rates, within the bonds of certain values, limits, considered normal in financial terms. These limit values, within the bonds of which the rates are kept, were established on the basis of the recommendation of some financial institutions and others are the result of the author's reasoning, displayed above, and checks and simulations carried out on a sample taken in the study, firms in difficulty, firms with superior financial performance and a good economic situation. The three areas, intervals, delineated for each rate are: the lower zone below the lower limit; the middle area between the lower and upper areas; the upper zone above the upper limit. Table 1. Financial diagnosis model The three zones delineated and points awarded Economic indicators The upper limit The interval between the two limits The lower limit 1 0,5 0 Return on asset [EBIT/Operating Asset] EBIT/OA [%] >13 8-13 <8 Return on equity [Net profit/shareholders equity] NP/SE [%] >15 10-15 <10 Sales/Break even sales S/BES >1,2 1,1-1,1 <1,1 Quick ratio [Acid test ratio] CA-I/CL >1 0,5-1 0,5 Total assets/Total debs TA/TD >1,6 1,25 <1,25 [Suppliers/Sales]/[Clients/Sales] [S/NS]/[C/NS] >1 0,5-1 <0,5 Net cash flow [Working capital-Working capital need] WC-NWC >0 0 <0 Auto-financing [Self financing/Fixed assets] SF/FA >1 0,5-1 0,5 Earnings before interest and taxes-tax of profit/rate of the loan repayment and interest [EBITTP]/[RLR+I] >2 1-2 <1 In the fourth stage, on the basis of the results for each indicator, points are assigned (ni) as follows:-0 for enrolment in the lower zone;-0.5 for the intermediate area;-1 for classification in the upper zone, these points are the equivalents of Unsatisfactory, Satisfactory, Good ratings. In the fifth stage, it will be calculated by 9 addition, the final score, on the basis of the points rating result for each indicator N= ni . The maximum 1 number of points is of 9 points, and the minimum number is of 0 points. This intervali between 0-9 will be divided into 4 grouping intervals. The groups established in this manner shall be considered homogeneous having in mind the medium in each group and the coefficient of variation. The evaluation grid for the financial diagnosis is as follows: Table 2. Grid. of financial diagnosis Group interval State Society financially The probability of bankruptcy 0-2,5 Unsatisfactory Very high probability of bankruptcy 2,51-5 Satisfactory High probability of bankruptcy 5,01-7,5 Good condition Low probability of bankruptcy 7,51-9 Very good condition Very low probability of bankruptcy Ioan Bircea / Procedia Economics and Finance 3 (2012) 1134 – 1140 4. Discussion Following a comparative analysis on some models of financial diagnosis used by banks, BRD model, Raiffeisen Bank model, etc., or specialists in various fields, MEFAT model, AG model etc., I observed that banking models are developed mainly to check the reliability, the repayment ability and the worthiness of the debt and that the models developed by specialists, apart from the fact that they have a high number of indicators, have a high degree of subjectivity by assigning some value coefficients to the rates. I consider being more objective the method based on the points resulted from classifying the indicators between certain limits considered normal from a financial standpoint. Overcoming these limits, by means of the resulting values of the indicators, are due to causes that can trigger or worsen the health of companies. The most used global diagnostic method is based on the SWOT matrix, but as with any method, it has its limits. From among these limits we mention: the qualitative character; a complex method based on a large number of indicators, determining the strengths-the weaknessesthe opportunities and the risks, requires training and experience of the one who interprets the values of the calculated indicators. The methods based on the estimation of risk of bankruptcy by score "Z", the Altman model, the Canon Holder model, the Anghel model, etc., involve selecting the financial rates based on their independence or on a weak correlations between them. Otherwise, an economic event is multiplied in the score by the agency of the other installments. The coefficients of importance of each installment being established on the basis of the least squares method, following the observations of the group of companies considered healthy and unhealthy from a reasonable accuracy, in time, unless measures are taken to update the variables considered and or recalibrate the model, their accuracy will diminish Armeanu et al., 2012. If in the study carried out, we observed the condition of independence of the rates, weak correlation coefficient, the model presented would encapsulate only 4 indicators, profitability, intermediary liquidity, financial solvency, financial intermediate average payment to suppliers/average receivables collection. In the new model, consisting of the four indicators, on the basis of the studied sample, the result states that the score, the resultant variable, is influenced in the greatest proportion by solvency. 5. Conclusions The financial diagnosis presented is checked only for the sample of firms selected from Romania, listed and unlisted. In some situations, the manager must make fast and pragmatic decisions, as such he needs radiography of the economic-financial situation to identify the causes of the dysfunctions, estimates the risks to which the company is exposed in order to determine the measures to be taken. In this context we recommend the proposed model of financial diagnosis both to managers -as a support for financial decisions, to banks- for analyzing their clients with a view to giving them a credit, and to all those interested in the knowledge of the economic-financial situation and internal risks. Through the calculated level of the indicators and the limits imposed, it is directly indicated which indicator is in charge of the score achieved. Based on the resulted score, according to the foundation scale, the economic condition of the society and the likelihood of bankruptcy are indicated. The model shown takes into account only the financial aspects, neglecting the aspects of a non-financial nature, considering them, to a certain extent, to be responsible for the evolution of the others. A more complex model of diagnosis that analyzes the company also from different points of view: judicial, commercial, human resources, technical potential, managerial activity etc., implies a thorough documentation, time and financial resources etc. 1139 1140 Ioan Bircea / Procedia Economics and Finance 3 (2012) 1134 – 1140 References p.126 -