Corporate Financial Distress: Restructuring and Turnaround 9781839829819, 9781839829802, 9781839829826, 1839829818

Table of contents :
Cover
Corporate Financial Distress
Corporate Financial Distress: Restructuring and Turnaround
Copyright
Table of Contents
List of Tables and Figures
About the Author
Preface
1. Corporate Distress and Financial Equilibrium: Genesis and Prognosis
1. Introduction and Background
2. Defining Corporate Distress: From Decline to Crisis
3. Crisis Factors: Identification, Handling and Governance
3.1 The Time Factor
3.2 Internal Causes
3.2.1 Inefficiency Crisis
3.2.2 Overcapacity Crisis
3.2.3 Product-related Crisis
3.2.4 Crisis Related to Lack of Planning and Innovation
3.3 External Causes: A Holistic Vision
4. Business Distress: The Importance of the Financial Structure Equilibrium
4.1 Financial Requirements and Their Constant Variability
4.2 Interdependence and Complementarity of the Company's Different Sources of Financing
4.3 The Choice of the Most Convenient Financial Structure and ‘Leverage’
4.4 Assessment of the Financial Equilibrium
2. Corporate Recovery Plans between Value Protection and Management Turnaround
1. Corporate Financial Distress and Continuity: The Protection of Business Value. National, Economic and Legal Dimensions
2. The Feasibility of a Recovery Business Plan: Best Practice Principles (CNDCEC)
3. Turnaround Strategy of a Financially Distressed Company
4. Developing a Business Turnaround Plan
3. Financial and Operational Business Turnarounds: Execution and Monitoring Complexity (*)
1. The Recovery Project, Its Complexity and Execution
2. Company Organisation: A Strategic Resource in the Recovery Process
3. Organisational Recovery as an Element of the Action Plan
4. Feasibility of the Recovery Financial Plan as a Result of a Correct Execution Process (Deployment)
5. The Monitoring of the Recovery Business Plan
4. Common Characteristics of Firms in Financial Distress and Prediction of Bankruptcy or Recovery: An Empirical Research Ca ...
1. Overview of Corporate Financial Distress and Bankruptcy (with a Special Focus on Italy) and ‘Early Warning’ Signs
2. The Company Recovery in Theoretical and Empirical Research Work
3. An Empirical Analysis by the University of Pisa in 2012 on the Correlation between Financial Flows and Economic Performa ...
4. Empirical Analysis by the University of Pisa in 2013 on: (a) Cash Flow and Correlations with the Economic Performance of ...
5. Corporate Crises, Weak Signals and Debt Restructuring: An Empirical Analysis in 2014–2015 by Bocconi University and SDA ...
6. Business Administrative Systems (BAS) and Bankruptcy Financial Distress (Based on the Observatory on Corporate Crisis – ...
6.1 Reorganisation Strategies and Administrative Systems
6.2 Business Administrative Systems in Financial Distress Situations
6.3 Results
7. Innovative Empirical Research by Bocconi University and Parthenope University in 2018 on Corporate Recovery over a 10-ye ...
8. Empirical Research for the Predictive Ability of Cash Flows for Measuring Firm Performance (2020)
8.1 Data Source
8.2 Regression Model
8.3 Results
9. Conclusions
5. Business Case: The Financial Restructuring of the ‘Alpha’ Group (2013–2015)*
1 The ‘Alpha’ Group and Its Business Model Over Time
2 The Reference Market and Sector
3 Causes of the Alpha Group Crisis
3.1 Exogenous Causes
3.2 Endogenous Causes
4 Recovery Actions: The 2013–2015 Financial and Strategic Recovery Plan
5 The Proposal of a Financial Intervention
6 A Successful Turnaround: Overcoming the Financial Crisis Situation of the Alpha Group
7 The Achievement of the Commercial, Economic, Equity and Financial Objectives of the Recovery Plan during the Turnaround P ...
8 The Group's Performance in the Recovery Phase (2013–2015)
9 The Prospective Financial Balance: Guidelines and Strategic Objectives of the Post Turnaround Plan (2016–2018)
10 From Financial Crisis to Value Creation: The Search for a Partner to Foster International Growth
11 Conclusions
References
Index

Citation preview

Corporate Financial Distress

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Corporate Financial Distress: Restructuring and Turnaround BY DR ALBERTO TRON Bocconi University, Italy

United Kingdom – North America – Japan – India – Malaysia – China

Emerald Publishing Limited Howard House, Wagon Lane, Bingley BD16 1WA, UK First edition 2021 Copyright © 2021 Emerald Publishing Limited Reprints and permissions service Contact: [email protected] No part of this book may be reproduced, stored in a retrieval system, transmitted in any form or by any means electronic, mechanical, photocopying, recording or otherwise without either the prior written permission of the publisher or a licence permitting restricted copying issued in the UK by The Copyright Licensing Agency and in the USA by The Copyright Clearance Center. Any opinions expressed in the chapters are those of the authors. Whilst Emerald makes every effort to ensure the quality and accuracy of its content, Emerald makes no representation implied or otherwise, as to the chapters’ suitability and application and disclaims any warranties, express or implied, to their use. British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library ISBN: 978-1-83982-981-9 (Print) ISBN: 978-1-83982-980-2 (Online) ISBN: 978-1-83982-982-6 (Epub)

Table of Contents

List of Tables and Figures About the Author Preface

Chapter 1 Corporate Distress and Financial Equilibrium: Genesis and Prognosis 1. Introduction and Background 2. Defining Corporate Distress: From Decline to Crisis 3. Crisis Factors: Identification, Handling and Governance 3.1 The Time Factor 3.2 Internal Causes 3.2.1 Inefficiency Crisis 3.2.2 Overcapacity Crisis 3.2.3 Product-related Crisis 3.2.4 Crisis Related to Lack of Planning and Innovation 3.3 External Causes: A Holistic Vision 4. Business Distress: The Importance of the Financial Structure Equilibrium 4.1 Financial Requirements and Their Constant Variability 4.2 Interdependence and Complementarity of the Company’s Different Sources of Financing 4.3 The Choice of the Most Convenient Financial Structure and ‘Leverage’ 4.4 Assessment of the Financial Equilibrium

ix xiii xv

1 1 4 7 7 8 8 9 9 9 9 11 11 14 18 22

vi

Table of Contents

Chapter 2

Corporate Recovery Plans between Value Protection and Management Turnaround 1. Corporate Financial Distress and Continuity: The Protection of Business Value. National, Economic and Legal Dimensions 2. The Feasibility of a Recovery Business Plan: Best Practice Principles (CNDCEC) 3. Turnaround Strategy of a Financially Distressed Company 4. Developing a Business Turnaround Plan

Chapter 3 Financial and Operational Business Turnarounds: Execution and Monitoring Complexity 1. The Recovery Project, Its Complexity and Execution 2. Company Organisation: A Strategic Resource in the Recovery Process 3. Organisational Recovery as an Element of the Action Plan 4. Feasibility of the Recovery Financial Plan as a Result of a Correct Execution Process (Deployment) 5. The Monitoring of the Recovery Business Plan Chapter 4 Common Characteristics of Firms in Financial Distress and Prediction of Bankruptcy or Recovery: An Empirical Research Carried out in Italy 1. Overview of Corporate Financial Distress and Bankruptcy (with a Special Focus on Italy) and ‘Early Warning’ Signs 2. The Company Recovery in Theoretical and Empirical Research Work 3. An Empirical Analysis by the University of Pisa in 2012 on the Correlation between Financial Flows and Economic Performance (as a Predictive Element of the Crisis) 4. Empirical Analysis by the University of Pisa in 2013 on: (a) Cash Flow and Correlations with the Economic Performance of Italian Listed Companies and (b) Predictive Capacity of Past Operating Cash Flows and Profits over Future Operating Cash Flows and Profits

25

25 32 37 43

51 51 55 56 60 64

67

67 68

69

73

Table of Contents 5. Corporate Crises, Weak Signals and Debt Restructuring: An Empirical Analysis in 2014–2015 by Bocconi University and SDA Bocconi 6. Business Administrative Systems (BAS) and Bankruptcy Financial Distress (Based on the Observatory on Corporate Crisis – OCI Survey (2011)) 6.1 Reorganisation Strategies and Administrative Systems 6.2 Business Administrative Systems in Financial Distress Situation 6.3 Results 7. Innovative Empirical Research by Bocconi University and Parthenope University in 2018 on Corporate Recovery over a 10-year Observation Period (2007–2016) 8. Empirical Research for the Predictive Ability of Cash Flows for Measuring Firm Performance (2020) 8.1 Data Source 8.2 Regression Model 8.3 Results 9. Conclusions

Chapter 5 Business Case: The Financial Restructuring of the ‘Alpha’ Group (2013–2015) 1. The ‘Alpha’ Group and Its Business Model Over Time 2. The Reference Market and Sector 3. Causes of the Alpha Group Crisis 3.1 Exogenous Causes 3.2 Endogenous Causes 4. Recovery Actions: The 2013–2015 Financial and Strategic Recovery Plan 5. The Proposal of a Financial Intervention 6. A Successful Turnaround: Overcoming the Financial Crisis Situation of the Alpha Group 7. The Achievement of the Commercial, Economic, Equity and Financial Objectives of the Recovery Plan during the Turnaround Period

vii

79

81 82 84 85

88 94 94 95 95 97

101 101 102 105 106 107 109 114 118

118

viii

Table of Contents 8. The Group’s Performance in the Recovery Phase (2013–2015) 9. The Prospective Financial Balance: Guidelines and Strategic Objectives of the Post Turnaround Plan (2016–2018) 10. From Financial Crisis to Value Creation: The Search for a Partner to Foster International Growth 11. Conclusions

119

128 136 136

References

139

Index

161

List of Tables and Figures

Chapter 1 Table 1.1. Table 1.2. Table 1.3.

Chapter 2 Table 2.1. Table 2.2. Table 2.3. Chapter 4 Table 4.1. Table 4.2. Table 4.3. Table 4.4.

Table 4.5. Table 4.6.

Positive Margin Structure Hypothesis. Hypothesis of Positive Revolving Fund. Assumptions of Negative Net Working Capital (NWC).

Italian Stock Exchange (Borsa Italiana) Business Plan Guidelines. Analysis of the Financial Situation. Statement of Liquidity.

Analysis of the Cash Flow Statements of the Sample Companies. Correlations between Financial Flows and Examined Profitability Ratios. Correlations Highlighted by the University of Pisa/ ANDAF’s Research. Correlations between Working Capital Flow (2004–07) and Average Values of Profitability and Market Value Indices (2008–2009). Correlations between Net Working Capital (2004–2007) and Profitability Indices (2008–2009). Correlation between Net Working Capital (2004–2007) and Average Profitability Indices (2010–2011).

15 15 15

33 49 49

70 71 72

73 73

74

x

List of Tables and Figures

Table 4.7.

Table 4.8.

Table 4.9.

Table 4.10.

Table 4.11.

Table 4.12. Table 4.13. Table 4.14. Table 4.15.

Chapter 5 Table 5.1. Table 5.2. Table Table Table Table Table

5.3. 5.4. 5.5. 5.6. 5.7.

Correlation between Net Working Capital (2004–07) and Precise Profitability Indices (2010–2011). Analysis of the Predictive Ability of Operating Cash Flow and Profits in Relation to Operating Cash Flow in the Period 1998–2004. Dependent Variable: Operating Cash Flow at Time ‘t’. Analysis of the Predictive Ability of Operating Cash Flow and Profit in Relation to Operating Cash Flow in the Period 2005–2011. Dependent Variable: Operating Cash Flow at Time ‘t’. Analysis of the Predictive Ability of Operating Cash Flow and Profits in Relation to Operating Cash Flow in the Period 1998–2004. Dependent Variable: Net Profit at Time ‘t’. Analysis of the Predictive Ability of Operating Cash Flow and Profits in Relation to the Operating Cash Flow in the Period 2005–2011. Dependent Variable: Net Profit at Time ‘t’. Variable Description. Headquarters of the Companies Included in the Sample. Correlation Analysis and Following Regression Analysis Carried out on the Selected Sample. Correlation Analysis of Dependent and Independent Variables.

Customer Segments. Details of Consolidations by Company and Credit Institutions. Past Due Items. Credit Lines. Recovery Actions and Objectives Achieved. Evolution of NFP 2013–2015 Plan vs Real. Characteristic KPI-Ratio 2013–2015 Plan vs Real.

74

76

77

77

78 86 89 92 96

104 115 117 117 120 125 126

List of Tables and Figures

Table 5.8. Table 5.9.

Chapter 1 Figure 1.1.

Sensitivity and Stress Test Plan 2016–2018 Analysis Criteria. Sensitivity and Stress Test Plan 2016–2018 Analysis.

xi

134 135

Figure 1.2.

The Four Stages of Crisis according to the Traditional Approach (Guatri, 1995). The Path to the Crisis.

6 6

Chapter 2 Figure 2.1.

Business Plan Structure.

46

The Turnaround Road Map. KPI Scorecard Monitoring. Sensitivity Analysis and Determination of ‘Delta-Performance’ Scenarios. Deployment Action Plan. Monitoring Framework.

54 59

Chapter 3 Figure 3.1. Figure 3.2. Figure 3.3. Figure 3.4. Figure 3.5. Chapter 4 Figure 4.1. Figure 4.2. Figure 4.3. Figure 4.4. Figure 4.5.

Chapter 5 Figure 5.1. Figure 5.2. Figure 5.3.

Enabling Factors of the Processes of Strategic and Operative Turnaround. ROS Trend (%) for the Companies Included in the Different Samples. ROA Trend (%) for Companies Included in the Different Samples. D/E Trend for the Companies Included in the Different Samples. Debt/EBITDA Trend for the Companies Included in the Different Samples.

2007–2011: Market Trend by Product. Market Dimensions. Market Dimensions.

62 63 65

83 90 91 91 93

103 104 104

xii

List of Tables and Figures

Figure Figure Figure Figure Figure

5.4. 5.5. 5.6. 5.7. 5.8.

Figure 5.9. Figure 5.10. Figure 5.11. Figure 5.12. Figure 5.13. Figure Figure Figure Figure

5.14. 5.15. 5.16. 5.17.

Figure 5.18. Figure 5.19. Figure 5.20. Figure 5.21. Figure 5.22. Figure 5.23. Figure 5.24. Figure Figure Figure Figure

5.25. 5.26. 5.27. 5.28.

Trend in Production Value. EBITDA Margin Evolution 2010–2012. Cost Savings 2010–2012. NFP/EBITDA, NFP/NE (2010–2012). Causes of the Crisis, Recovery Actions, Operational Objectives, Strategic Objectives. Effects of Recovery Actions on Beta’s Performance. KPI 2012–2015. Details of Consolidations by Company and Credit Institutions. Staff 2013–2015 (Recovery Business Plan vs Real). Personnel Cost Impact 2013–2015 Recovery Business Plan vs Real. Turnover Trend Beta 2013–2015 Net Revenues 2013–2015 Plan vs Real. Economic Performance 2013–2015 Plan vs Real. EBITDA Trend 2013–2015 Recovery Business Plan (RBP) vs Real. Revenues, EBITDA and Cumulated Net Result 2013–2015 Recovery Business Plan vs Real. Evolution of the NFP 2013–2015. NFP/PN – NFP/EBITDA 2013–2015 Plan vs Real. Various Index Relating to the RBP vs Actual (see Previous Table 5.7). Financial Covenant 2013–2015 Plan vs Real. Alpha Group – ‘Z-Score PMI’ Distress Risk Index. Alpha Group – ‘Z-Score PMI’ Distress Risk Index 2010 to Forecast 2018. EBITDA Bridge 2015–2018. PFN Trend 2012–2018E. PFN/EBITDA 2012–2018E. NWC Trend.

106 109 109 110 111 112 114 116 120 121 121 122 123 124 124 125 126 127 128 129 130 131 132 132 132

About the Author

Professor Alberto Tron Since 2016, Alberto Tron has been a Professor of Corporate Finance at the University of Milan, Bocconi. From 2006 to 2019, he was Professor of Accounting and Business Economics at the University of Pisa. Over his professional and university career, he has co-authored 13 books, wrote more than 50 publications in national and international journals and has been a speaker at numerous conferences on corporate finance, financial market law and regulation, accounting and financial reporting issues linked to supervisory bodies, auditing and business crisis management. Member of ADEIMF (Associazione dei Docenti di Economia degli Intermediari e dei Mercati Finanziari e Finanza Aziendale – the Academy Association of Financial Markets and Corporate Finance Professors) and SIDREA (Societ`a Italiana Docenti di Ragioneria ed Economia Aziendale – the Academy Society of Business Administration Professors). Member of ANDAF (Associazione Nazionale DirettoriAmministrativi e Finanziari – the National Association of Chief Financial Officers) and Chairman of ANDAF’s Financial Reporting Standards Committee. Member of the working groups on Italian and International accounting standards and financial instruments at the Organismo Italiano di Contabilit`a (OIC – the National Accounting Standard Setter). Member of working groups on Italian valuation standards at Organismo Italiano di Valutazione (OIV – the Italian valuation standard setter member of IVS). Expert member of the Company Valuations Committee and Non Performing Loans Committee set up by the Consiglio Nazionale dei Dottori Commercialisti e degli Esperti Contabili – CNDCEC (the National Council of Chartered Accountants).

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Preface

This book aims to provide an overview of the ongoing academic debate about corporate financial distress and how academics, experts and business managers approach it both at the international level and in the Italian context. In particular, five main areas have been investigated. In the first chapter, we offer a complete and in-depth analysis of corporate financial distress, bankruptcy and recovery turnarounds as the current academic debate updates existing literature and provides new materials to highlight. As is generally known, research on financial distress and corporate crisis management is relatively recent if compared to studies on financially sound enterprises.The corporate health of firms is of considerable concern for various stakeholders, such as investors, managers, policymakers and industry actors. Nowadays, the main concern of companies, regardless of their size and sector, is the threat of insolvency, and this emphasises the relevance of preventing and mitigating a corporate downturn. Both academics and professionals have contributed substantially to crisis literature: professionals and managers generally focus on how to procedures and techniques while academics and scholars address more theory-based response strategies, including the corporate apologetic approach, financial distress prediction, image restoration or specialised fields such as product-harm crises. In this chapter, the importance of financial equilibrium is analysed. In recent decades, finance gained more and more relevance and now it has a strategic role in company governance. Today, finance is not only related to the other company sectors through its influence on their choices and their operating processes, but it also determines new strategies and new business models. In the second chapter, the adopted perspective – specifically focused on the going concern evaluation – outlines the path of business value protection achieved by turnaround management. The starting assumption is that no crisis is intrinsically unrecoverable: the problem is not the existence of a solution to the crisis itself, but rather the economic convenience and willingness (of the actors involved in the recovery process) to provide the necessary means for the successful achievement of equilibrium conditions. The suitable tools to solve a corporate crisis have to reconcile the efficiency principle (and, therefore, the lower cost of management) and that of equity (that is, the maximum satisfaction of stakeholders) to avoid failure. For the negotiation of the crisis business plan, the restructuring or industrial/ strategic turnaround assumes a role of absolute pre-eminence over any considerations of a financial and corporate nature. The entrepreneur is required to draw

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Preface

up an adequate and consistent turnaround plan, or reorganisation. The plan represents the essential tool to evaluate the technical and economic feasibility of the overall recovery project. A document drawn up in 2017 by the National Council of Chartered Accountants and Accounting Experts (CNDCEC with AIDEA-ANDAF-APRI-OCRI) entitled Guidelines for the preparation of the Recovery Business Plan (hereafter Principi) highlights how the basic aim is to rationalise and plan the business choices and summarise them in a complete document, which should be representative and easily readable. If the Recovery Business Plan (hereafter ‘RBP’) respects the principle of clarity, the recipient will immediately understand the business idea underlying it, the subsequent objectives, the tools and solutions to achieve it and the resources to be used. In the third part, we point out that a successful financial restructuring plan requires careful planning of the interventions deemed necessary to solve the crisis, and the punctual identification of the related timing. The time component, in particular, represents a constraint the scope of which is frequently underestimated as the company faces a crisis situation. Research into execution, monitoring and performance is described here; as the recovery plan implies the pursuit of a specific strategy, it is necessary to prepare an organisational structure to support the strategy implementation. The literature has largely focused on the strong links between strategies and structures. The key elements of a performing organisational model are seemingly conceptual but, as a matter of fact, they have strong features of concreteness and measurability which are necessary to assess any possible deviations between the planned objectives and the results which are achieved as we proceed with the recovery. The analysis of the deviations is fundamental to prepare the suitable corrective actions during the implementation of the recovery project. In order to minimise the risk of a possible inadequate implementation, the best practice principles provide for a specific deployment and monitoring phase to mitigate any unexpected unsatisfactory under-performance, which, in some cases, could undermine the success of the recovery operation. In the fourth section, empirical research carried out in Italy underlines the common characteristics of firms under financial distress and the possible prediction of bankruptcy or recovery. In a research study carried out in 2012 by the University of Pisa in collaboration with ANDAF (Associazione Nazionale Direttori Amministratori Finanziari – Italian Financial Executives Association), on a sample of 52 industrial and service companies featuring the worst performance listed on the Italian Stock Exchange (Borsa Italiana S.p.A.), an attempt was made to test if the financial flows could provide valid information on their future economic performance. The above-mentioned research was applied in 2013 to the same sample of companies listed on the Italian Stock Exchange (Borsa Italiana S.p.A.), extending the correlation of financial flows – recorded in the period 20042007 – with the average economic performance values of the 2010-2011 period; the correlation values, using Spearman’s analysis, as in the 2012 research, were reinforced by the 2013 empirical analyses on the average profitability values recorded in the years 2010–2011. Innovative empirical research by Bocconi University and Parthenope University in 2018 on corporate recovery over a 10year observation period (2007–2016), in partnership with one of the main national

Preface

xvii

banks, had the objective of investigating the common elements in successful recovery processes, in order to predict the outcome of a certain type of recovery operation and analyse some specific features (whether they were present or not) at the beginning of the restructuring phase. At the end of the chapter, we deal with a recent study (2020) the main objective of which was to contribute to existing research on the predictive ability of cash flows to forecast future cash flows and performance by providing new evidence from the Italian business context, which is significantly under-explored. In order to fill this gap, the ability of cash flows to predict future cash flows was investigated as well as the ability of cash flows to provide decisive investment information both for the individuals inside the organisations and the subjects outside them. The analysis was carried out on a sample of 168 Italian listed companies in the 2008-2017 period. The final chapter analyses a business case that deals with the strategic and financial restructuring of an industrial group manufacturing products for schools and leisure. The recovery process highlights how, by facing a turnaround process from a strategic point of view, by searching for unexpressed potential within the company system, exploiting industrial and financial synergies and identifying new market opportunities, it is possible to achieve a complete reversal of a situation of imbalance. The results achieved at the end of the Recovery Business Plan show, in fact, how a reversal trend is possible through specific actions focused on the recovery of profitability and on value creation, and how that progressively affects functions, processes and the whole management. For a successful recovery plan, simple recipes – made up only of staff cuts and/or the dismissal of unprofitable activities (products, segments, consumer groups and geographical areas) – are not enough: an ‘organic’ recovery needs to be implemented. In the recovery process, the accurate survey carried out at the very beginning of the corporate structure revealed the areas to rapidly act upon, as well as the Group’s latent potential and strengths to achieve a successful turnaround. Lastly, it should be noted that the recovery process identified all the responsibilities for each phase of the process, thus allowing the company management to periodically check the correct fulfilment of the actions and monitor the progress towards the desired objectives. The problems regarding the Group’s crisis represented the opportunity to achieve a deep internal reorganisation, a targeted cost rationalisation, a debt restructuring and a renewed commercial policy. The turnaround did not focus on resolving the expressive symptoms of the crisis, but aimed at improving the overall management of the company. The turnaround strategy was successful and allowed interesting development opportunities to be taken at the right time even during a difficult period. The role of time is emphasised throughout the book as an essential variable. The going concern evaluation must be particularly timely if we want to preserve corporate value. And again, time is capital in the restructuring of financially distressed companies as the prolongation of a crisis deeply affects the possibility of any recovery. Milan, Italy Alberto Tron

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Chapter 1

Corporate Distress and Financial Equilibrium: Genesis and Prognosis 1. Introduction and Background Research on financial distress and corporate crisis management is relatively young in comparison to studies on financially sound enterprises. The corporate health of firms is of considerable concern for various stakeholders, such as investors, managers, policy makers and industry participants. Nowadays, the main concern of companies, regardless of their size and sector, is the threat of insolvency. There are several reasons for this strong focus on preventing and mitigating a corporate downturn. Traditionally, financial economics literature has portrayed financial distress as a costly event, the possibility of which is important in determining firms’ optimal capital structure (Opler & Titman, 1994). A company under financial distress is a company that is struggling with promises made to its creditors. Financial distress can be defined as the point where cash flows are lower than the firm’s current obligations (Wruck, 1990). If a company is unable to meet those obligations, it is in default (Vassalou & Xing, 2004) and its creditors may start legal proceedings to sue for bankruptcy. This book provides evidence on distressed firms (Chapter 2) from a civil-law country, Italy, that has traditionally been considered a country with rather weak shareholder and quite strong creditor protection (La Porta, Lopez-de-Silanes, Shiefer, & Vishny, 1998). Most existing studies have so far almost exclusively looked at the US (Altman & Hotchkiss, 2005); however, the US has a financial market that is usually characterised by stronger shareholder and weaker creditor rights if compared to Italy. Differences in legal regimes are likely to matter for changes in corporate oversight and turnarounds.

Corporate Financial Distress, 1–23 Copyright © 2021 by Emerald Publishing Limited All rights of reproduction in any form reserved doi:10.1108/978-1-83982-980-220211002

2

Corporate Financial Distress

For an Italian company in distress and heading towards default there are three options: (1) make a deal with creditors, possibly renegotiating obligations. (2) voluntarily file for bankruptcy, and either be auctioned off as a going concern or liquidated and sold piecemeal. (3) file for corporate reorganisation at the local district court. Independently of the local legal regime, this area has become of public concern due to the recent global financial crisis (2008–2009) that witnessed failures of many venerable institutions which were rescued by governments (Bear Stearns, AIG, Fannie Mae & Freddie Mac, Washington Mutual, Anglo Irish Bank, Royal Bank of Scotland, Northern Rock, etc.). The resolution mechanisms for both the private and public sector use corporate finance paradigms to develop financial distress tools. Both academics and practitioners have contributed substantially to crisis literature: practitioner–business managers have generally focused on how to procedures and techniques (Devlin, 2006; Fink, 1986; Regester & Larkin, 2005; Ruff & Aziz, 2003; Seymour & Moore, 2000;), while academic scholars have tended to address more theory-based response strategies, including the corporate apologetic approach (Hearit, 1995, 2006; Outecheva, 2007; Rowland and Jerome, 2004), financial distress prediction (Altman, 1968; Altman, Hatzell, & Peck, 1995; Balcean & Ooghe, 2006; Beaver, 1966; Bose, 2006; Doumpos & Zoupounidis, 1999; Foster, 1986; Kumar & Ravi, 2007; Lin, 2009; Ravisankar, Ravi, & Bose, 2010; Ross, Wesrtefield, & Jaffe, 2010; Sun & Li, 2008), image restoration (Benoit, 1995, 2000; Burns & Bruner, 2000; King, 2006) and post-crisis discourse (Coombs, 2004; Ulmer, Seeger, & Sellnow, 2007) or specialised fields such as product-harm crises (Laufer & Coombs, 2006). Notable academics have identified and categorised different types of financial distress and corporate crises, in the belief that such categories may help in developing the most appropriate response strategies (Jaques, 2009). Lerbinger (1997), for instance, described seven categories, Coombs (1999) formulated five different ranges, while Gundel (2005) explored in detail the role and properties of crisis types. Since first devoting its attention to the subject, academic literature has emphasised the difficulties in defining corporate financial distress because of the incomplete and arbitrary nature of any criteria in classifying it (Keasey & Watson, 1987). There is no general consensus on how financial distress affects corporate performance, but it is costly (Opler & Titman 1994) and needs to be investigated. Altman (1993) relates corporate financial distress to unsuccessful business enterprise and defines four generic terms commonly used in literature which are: failure, insolvency, bankruptcy, and default. Corporate financial distress remains, nonetheless, a vague term (Altman & Hotchkiss, 2005) that does not correspond to an absolute condition such as bankruptcy or insolvency. Despite a lack of an exact agreement on crisis definition and typologies, there is at least a reasonable level of commonality. Corporate financial distress identifies a

Corporate Distress and Financial Equilibrium: Genesis and Prognosis

3

status that is extended in time, embracing the failure path and (both possibly and ultimately) the event of bankruptcy. According to academic literature, the life of a company is characterised by positive and negative circumstances which, taking place with a certain degree of intensity, determine its economic viability (Alas & Gao, 2010; Cazdyn, 2007; Giacosa & Mazzoleni, 2011; Giannessi, 1982; Onida, 1960). The crisis is often seen as a recurring event in ordinary corporate life (Bradley, 1978; Gcaza & Urban, 2015; Holmgren & Johansson, 2015; Kadarova, 2010; Kadarova, Markovic & Mihok, 2015; Lagadec, 1991a, 1991b; Pollifroni, 2012; Pollifroni, Militaru & Socaciu, 2014). During the life of a company, alternation between negative and positive phases may take place either during a temporal phase (or cyclical in time) or it may be a permanent state (Amaduzzi, 1949; Bastia, 1996; Giacosa, 2016; Guatri, 1995; Paolini, 1998; Zanda, 2015; Zappa, 1956). In a situation characterised by increasingly compressed margins of profitability, the spread of the 2008–09 financial and economic crisis caused difficulty for a lot of medium and medium-large companies to generate sufficient sales volumes to achieve at least a break-even point. Not to mention smaller companies, which found themselves facing a critical situation, without the necessary conditions and resources (not only economic-financial) to deal with it. Academic literature has essentially been developed in two macro-areas of analysis: (1) the first is represented by studies focusing on the crisis of entire economic systems, productive sectors or geographical areas with clearly identifiable borders; (2) the second area, instead, is represented by works related to the crisis of individual entities (Danovi and Quagli, 2015; Tedeschi-Toschi, 1990). In scholarship, sectorial crises are explained, in most studies, as a consequence of the specific weakness or physiological evolution of sectors, as well as in terms of the ineffectiveness of public support policies (Boeri, 1985, 1987; Dematt´e, 1979; Gros-Pietro, 1976; Podest`a, 1984; Prodi & Gobbo, 1980). Within these studies, finally, aspects of a more microeconomic nature begin to assume considerable importance as the real causes of corporate crisis, such as, for example, technological and organisational innovations related to production processes in specific sectors, or consumer behaviour related to the underlying demand trend for specific goods or services. Negative economic situations, in fact, give rise to an acceleration of processes related to the life cycle of a company, with possible sudden changes from a situation of expansion and growth to a situation of possible contraction and crisis. Guatri (1995) highlights, from an evolutionary perspective, that the process moving from decline to crisis includes four stages: (1) incubation, characterised by a decrease of economic and financial equilibrium; (2) periodic financial losses are significant and the entity’s intrinsic value starts to fall; (3) the mean profitability affects the cash flows and the reduced credibility implies a higher difficulty of borrowing; (4) explosion of the crisis that generates serious impacts at economic, managerial and financial levels, both internally and externally (Pozzoli & Paolone, 2017).

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Corporate Financial Distress

Despite this consideration, through the analysis of case studies, the examination of internal factors as causal factors of corporate crisis seems to be predominant if compared to the study of its environmental dynamics. The literature particularly emphasises the errors made in the strategic and managerial activities of the company (Argenti, 1976; Smart & Vertinsky, 1977). The relevance of external factors has only been highlighted in recent studies on changes in the political and social environment. Reference is made to contingent and unpredictable events with low probability, such as, for example, natural disasters and accidents at work (Billings, Milburn, & Schaalman, 1980; Lagadec, 1991a, 1991b; Reilly, 1993; Shrivastava, 1992). An appropriate classification of the reasons that led to the crisis is crucial in order to determine an effective response. The deeper and longer the crisis, the faster and wider the reaction required. In the majority of cases, there is not only one cause for the decline and so consequently the solution is to refer to different areas of intervention. Grant (2010) states that when the decline is prolonged, the response would likely be both strategic and financial. In this perspective, practice is progressively more oriented to providing models able to predict the phenomenon, and not only to declare its existence (CNDCEC, 2015). The analysis of a company crisis as commonly described in literature will be carried out in the following paragraphs, starting from balance sheet data and through analysis by indices or flows. The so-called financial analysis is necessary to understand the reasons and genesis of a crisis, as well as to reveal possible solutions. The following paragraphs introduce the complex phenomenon of corporate financial distress, illustrating its articulation in different phases of the corporate path, reviewing its definition and providing a re-assessment of the relevant academic literature and some guidelines for an optimal corporate financial structure (FS; for the prevention of financial distress).

2. Defining Corporate Distress: From Decline to Crisis Even if some studies have provided empirical evidence underlining that there is no direct relation between economic and financial distress (Senbet & Seward, 1995; Kahl, 2002a, 2002b), an economic crisis may lead to financial and/or economic distress if contribution from stockholders is missing and if there are no corrective actions. In general terms, distress exists when the company’s equilibrium cannot be reached under the current situation. If other actions are not taken, the firm is naturally destined to cease its operations. The concept of ‘economic distress’ is not very well developed. The literature most commonly refers to this concept by illustrating the aspects related to the above-mentioned economic equilibrium. The adopted notion of corporate crisis follows a hybrid and contingent approach. The analysis of the crisis, in fact, as well as the tools and models for its solution, cannot be formalised in a prescriptive and generalised way, as it requires a deep knowledge of the company and of the reference environment in which it operates. This vision accepts and integrates, according to the systemic theory, the definition of crisis according to the concepts of the Theory of Value (Fruhan, 1979;

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Guatri, 1991; Blyth, Friskey, & Rappaport, 1986), dedicating attention also to decline situations, i.e. to phases in which the pathology is still latent in the company structure (Danovi, 2003; Guatri, 1995). In particular, starting from the fundamental equation of value: W ¼ R=i

it is possible to define the concept of the company’s decline as the achievement of a negative change in a company’s economic value over time; hence the quote ‘a company is in decline when it loses value over time’. The definition of corporate crisis proposed by Guatri, based on the Theory of Value, considers, on the one hand, the awareness that the company will inevitably face moments of crisis during its life cycle and, on the other, the understanding that the crisis may be related to corporate events, but also to changes in the external environment. Given the fundamental equation of value (W 5 R/i), the crisis is correlated to a negative change in value, highlighting how decline and crisis may depend not only on a decrease in flows (internal events) but also on external events, that is a change in risk conditions (Danovi & Quagli, 2015). A situation of company decline is not only identified by the presence of economic losses or by a reduction in the related cash flows. To have a decline situation, the economic loss must be systematic and, at the same time, irreversible if no remedial action is taken. The measure of loss should not only be calculated on a final basis but should also refer to prospective flows. According to Guatri’s approach (1995), the crisis path can be described as a sequence of four dependent stages: for each of which, specific events may be observed (see following Fig. 1.1). Crisis results as a development and worsening of a situation of decline. Often this happens in conjunction with an external or internal trigger event (triggering factor). There are defined threshold limits for crisis indicators, beyond which the company could find itself needing to undertake a recovery process. The triggering event has to be considered as a crucial element in the binomial crisis-recovery because in absence of triggering events many companies risk turning into boiled frogs: they act ignoring the growing need for change until they fail (Tichy & Ulrich, 1984). According to this approach, the real risk of bankruptcy is just one of the possible forms in which the trigger event occurs (Danovi & Quagli, 2015) (see Fig. 1.2). A situation of financial tension entails recourse to the credit market, with the consequent negotiation of new loans or time extensions. This happens when the credibility of the company as an economic entity is at stake: the company needs to demonstrate the possible existence of future prospects for development and recovery. Otherwise, the refusal of credit on the part of the lenders drives the state of financial tension towards a real crisis, which can only be solved through the renegotiation of debt contracts and the opening of a restructuring proceeding. If no major industrial and financial restructuring measures are taken, the insolvency situation is usually irredeemable.

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Corporate Financial Distress

Fig. 1.1. The Four Stages of Crisis according to the Traditional Approach (Guatri, 1995). Source: Adapted from Guatri (1995).

Potential crisis

Governable”crisis

Irreversible crisis

W (economic capital value) Debt Liquidation value

CFO (Cash flow from Operation)

(earlywarnings/weaksignals)

Fig. 1.2.

The Path to the Crisis.

Given these concepts concerning crisis and decline, it is possible to propose a definition of recovery, and of restructuring, in terms of ‘recovery of value creation’. The combination of industrial and financial restructuring has often been debated, with reference to the prevalence and/or complementarity between the two phenomena.

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This seems to be related to the different visions of crisis, where – from time to time – the emphasis is placed on financial or on industrial aspects. According to the author, there is always the need to look at the crisis with a holistic and organic view, understanding its causes and implementing some integrated recovery policies. The analysis of the corporate crisis by means of economic-business instruments is essential for an effective and appropriate approach, implementation and verification of the recovery and/or restructuring policies. It is the continuous monitoring of the data coming from the management that makes it possible to perceive the presence of factors able to interrupt the balance of the company as a whole. Data processing also makes it possible to identify the nature and extent of the imbalance, understand the crisis, or the pathological situation, and to optimally choose the recovery policies and the instruments to adopt.

3. Crisis Factors: Identification, Handling and Governance As previously mentioned, the causes of the crisis can be multiple or single, latent or sudden, internal or external. It is therefore useful to identify a categorisation that can facilitate its comprehension. In this book, we will adopt the paradigm which distinguishes if a corporate crisis is either due to an operational and managerial incapacity or to a problem of an economic and financial nature. Several studies on corporate crises underline the difficulty in interpreting the phenomenon, in terms of effective assessment and presence of causal factors which may be qualified as internal and external to the company. Hence the difficulty in assigning them a specific weight. Studies show that, when analysing a company crisis, due attention must be paid to consideration of the human factor; it was correctly observed that ‘a crisis is always the result of a combination of unfavourable events inside and outside the company’ (Sciarelli, 1995).

3.1 The Time Factor Business management, even in a normal situation, inevitably involves a series of small, almost physiological, business imbalances occurring over time (Guatri, 1986). These critical situations do not necessarily lead to obvious disruptions for all stakeholders. It must be said, however, that the company structure is certainly placed under stress by these continuous, albeit small, moments of criticality. But especially in the presence of a shrewd management, it is possible to manage these imbalances and avoid situations of greater instability. In this view, the so-called company pathologies, normally present in the life of an enterprise, appear externally only when they enter the acute phase (Guatri, 1985). The dynamics of development of a crisis are defined as four widely accepted, distinct and identifiable stages: incubation, manifestation, financial imbalance and explosion (Guatri, 1986).

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Corporate Financial Distress

During the incubation period, the factors of decline generate some signals of imbalance which may be detected through the static and flow indices used in the financial analysis: these data may reveal the critical conditions and growing instability in which the company finds itself. The usefulness of setting up a system of preventive check-ups – with respect to the company crisis situation – is universally recognised and it is mainly based on quantitative analyses of the balance sheet and on the reconstruction of the flows that characterise the company (Amigoni, 1983; Bastia, 1996; Brugger, 1984; Caramiello, 1968; Cavalieri & Ferraris-Franceschi, 2005; Riparbelli, 1950). An effective management control system will allow for a timely identification of critical issues and provide ideas for the areas of intervention. During the manifestation phase, the loss of income flows and value of the company’s assets are explained in the final balance sheet data. The stages of financial imbalance and explosion make up the real crisis, which may result, as already mentioned, in disruption. Financial imbalance is the external manifestation of the serious moment of difficulty that the company is experiencing, through the income losses highlighted by cash flows and the loss of confidence of the reference environment. The explosion, on the other hand, is the moment when insolvency and possible disruption reach the company’s stakeholders.

3.2 Internal Causes Internal causes of crisis are commonly defined in literature as errors made when defining the company’s strategic orientation and/or particular management policies. In this perspective, the distinction between founding crisis and management crisis is worth analysing (Sciarelli, 1995). The former refers to the mistakes made in the structuring of a new company, which starts its activity with weak market positioning and insufficient resources. The second refers to events which occurred during the course of the company’s life, and more precisely, to the inability to adapt in accordance with the changing external environment.

3.2.1 Inefficiency Crisis This is the case when particular sectors of the company’s business do not provide services in line with the average of competitors. Generally, it is the area of production which is most affected, due to obsolete equipment, incapacity or scarcity of manpower, or inadequate use of technology. The intensity of operational inefficiency may be determined both in terms of product costs and of inefficiency indices. Inefficiency, however, should not only be considered in operations, as it may also affect the administration sector where similar situations may be attributed to more or less serious shortcomings of the information system. Then we have to consider financial inefficiencies in obtaining credit on the market and in planning capital investments through financial instruments featuring an unlikely economic return (Guatri, 1986).

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3.2.2 Overcapacity Crisis The origin of this type of crisis may be different, since there may be an overcapacity in production at the level of an entire business sector, leading to a reduction in the demand volume, with the consequent revenue fall. This sectorial overcapacity, the search for economies of scale, and mainly the fall of global demand due to the change in consumers’ tastes or habits may have a heavy impact on individual companies, and their market share depends on their capacity to react (Guatri, 1986).

3.2.3 Product-related Crisis This typology seems to be closely linked to the inefficiency crises described above. In this case, it is the inefficacy of the product offering compared to that of competitors. This results in a commercial loss of market share and in the reduction of the gross industrial margin. The variations in margins are due both to sectorial reasons and to a lack of innovation, quality problems, etc. in the individual company (Guatri, 1986).

3.2.4 Crisis Related to Lack of Planning and Innovation Companies sometimes set themselves the almost unique objective of achieving results in the short term, neglecting the preparation of the necessary conditions to achieve results in the long term as well. The consequence may be a progressive deterioration in the ability to create income and, therefore, in the capacity to resist the inevitable phases of market difficulty. Almost all companies affected by decline and/or crisis show shortcomings in their strategic planning. At the same time, the lack of innovation can be lethal too: both in small companies, where it is associated with entrepreneurial capacity itself, and in large companies, where the search for new productive combinations is entrusted to the R&D function (Frey, 2005). The empirical experience carried out by Slatter on 40 British companies (Slatter, 1984) shows that the most common internal causes are inadequate management and weak financial control (present in more than 70% of cases), but other factors such as operational ineffectiveness, weak demand or environmental problems are never far behind.

3.3 External Causes: A Holistic Vision The study of the company crisis can be traced back to the theoretical approach of ‘vital systems’ which interprets the evolutionary dynamics of the company in its ability to develop positive relationships with the multiple entities operating in the reference environment (Golinelli, 2000). According to this perspective, the company presents itself as a system, or rather as a composite organisation in which each component carries out a specific activity to achieve its goal. This system is to be considered open because its vitality depends on the ability to exchange the necessary resources with the external systems (in other words with the reference

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Corporate Financial Distress

environment), which will necessarily condition its evolutionary trends (Falini, 2011). Among the external causes in determining the company crisis, it is important to make reference to the so-called growth trap (Guatri, 1985). Some imbalances in companies are, in fact, related to their growth, when it is determined by incoherent objectives and methods. The growth path of the company structure involves the conscious assumption of high and voluntary risks, as opposed to those necessary for development (Canziani, 1986). In this context, it is commonly accepted that there are possible problems regarding the company’s growth and we can distinguish between: (1) growth that is not rationally planned and contains errors that are relevant for its implementation; (2) growth that is too fast in relation to the initial size of the company structure, which requires excessive debt and related financial imbalances; (3) growth linked to the personal interests of managers and not related to precise purposes of the company (Guatri, 1986). In crisis situations with an external matrix, the factors influencing the crisis cannot be controlled by the top management. A further problem is that of the frenetic rhythms that companies have to face in their growth path. In this case, the problem of short-term profitability may arise. In fact, in opposition to significant investments in intangible assets and, above all, the high cost of raising capital, the initial income is very limited, if not zero. In the opposite case, i.e. for companies with a high availability of capital to invest, a different problem may arise. In particular, some managers, attracted by higher visibility and earnings, may push the organisational structures towards a forced development and away from the core business because of the ease with which they can set up M&A operations (Porter, 1992). The weight of these choices results in a significant deviation of the company’s goals from the initial objectives of medium/long-term profitability. Concerning crises which have their origin in an external cause, the following reasons were identified in literature: (1) the financial markets, which, if weak, do not encourage companies to be listed on the stock exchange and, at the same time, do not foster their capitalisation; (2) possible shortcomings and inefficiencies of the banking systems, such as high costs of access to financing opportunities; (3) possible fluctuations in exchange rate systems; (4) lack of essential infrastructure; (5) tension in political scenarios. It is possible to assert that, with regard to a company pathological situation, ‘it is necessary to seek not only and not so much the causes, perhaps remote, that have determined it, but the reasons that at present do not allow the company to overcome it’ (Capaldo, 1977). Decline and crisis in most cases are determined by the coincidence of triggering factors, both internal and external, which often overlap and produce negative results. It is difficult, then, to evaluate the contribution of each single factor to the final collapse (Guatri, 1986). Studying the origins of a company crisis, with a view to possible restructuring processes, is more difficult if the company has in the meantime set up new entrepreneurial initiatives: in such a situation, the lack of an adequate time interval for evaluation, may make it difficult to separate factors of inefficiency in

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the use of resources from possible factors of inefficiency in the strategic choices (Guatri, 1986).

4. Business Distress: The Importance of the Financial Structure Equilibrium The company dynamically pursues a prospective economic balance in the continuous development of its management. Three fundamental factors contribute to this condition: (1) the economic balance, meant as the ability to continuously produce a satisfactory income flow in the long run; (2) the financial balance, consisting in the pursuit of solvency, both to survive in the present and to meet future capital requirements arising from the company’s development in the long term; (3) the capital balance, that is the ability to maintain solid assets to ensure its existence, development and growth through the balance between investment and financing, trying to limit financial dependence on third parties. The prospective achievement of an economic, financial and equity balance is at the basis of the management activity of each company. In fact, the loss of income capacity, combined with the increase in risks, causes a break in these balances and the emergence of a situation of decline, with the consequent degeneration into the state of crisis which constitutes its acute phase. In addition to these traditional concepts of equilibrium, there is also the organisational balance, i.e. the economically and socially useful state in which the company system should act (Cafferata, 2009).

4.1 Financial Requirements and Their Constant Variability Financial requirements are defined as the total amount of liquid assets needed to complete the production or sales processes in progress (Ferri, 1992). In other words, the measure of this requirement is connected with the total investments awaiting realisation, i.e. with the total real and net financial assets which appear in the company’s balance sheet (Bianchi, 1972; Dallocchio & Salvi, 2011; Galeotti, 2008; Tiscini, 2014; Tron, 2013). Before facing the analysis of the company’s financial needs, it should be remembered that their size varies according to the growing dimensions of the company. Since financing through equity or credit is complementary to financing through revenues, the size of the former varies, all other things being equal, in the opposite direction to the size of the latter. But the size of the latter, in turn, is a function of changing factors, since it is linked to the income flows, which are not necessarily uniform and constant. The capital requirement size is then a function of the monetary flows from revenues but, at the same time, it is influenced by the operating costs and, therefore,

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Corporate Financial Distress

by the changing combinations of these flows over time. The dynamics, terms and conditions of all cash flows, deriving from the company ordinary management, determine a certain randomness in the results.The financial area can increase the variability of the income and, therefore, the overall risk, to be added to the ‘operational risk’, a financial threat deriving from the imperfect correspondence, in terms of duration, financial parameters, currency of denomination, etc., between the activities to be financed and the corresponding funding sources. The business activity is subject to a ‘typical’ risk consisting in the possibility that production management may not be able, over time and with the necessary continuity, to generate revenues to an extent suitable to cover all structural costs. The income variability, which is thus determined, is normally defined as ‘operational risk’. The financial needs and sources must then be correlated in such a way as to allow the company an efficient economic, equity and monetary balance. The FS has to then be calibrated to avoid the occurrence of liquidity crises, on the one hand, and situations of excessive monetary availability on the other. Financial shortages can constitute elements of considerable difficulty for the company. Particular consideration should be given to the situation where the company’s long-term needs (e.g. the plants) when financed by short-term sources (e.g. current account credit facilities) lead to a financial mismatch. If the credit lines are revoked, the company will have to either activate (where available) a new form of funding, or use its assets with significant damages to the production process and to the very existence of the company itself. Indeed, liquidity shortages may lead to real difficulties in implementing investment policies and repaying maturing debts. On the other hand, systematic cash surpluses lead to non-physiological opportunity costs, due to the generally higher cost of funding compared to the return on liquid assets.To avoid situations of financial imbalance such as those highlighted above, it will therefore be necessary to identify the company’s different financial needs and achieve the best possible correlation with the available financing sources. In determining an overall financial requirement, we have to distinguish a long-term need from a temporary need. In theory, the long-lasting part should coincide with the fixed assets, i.e. investments in fixed assets, while the temporary part should coincide with the working capital, which is made up of various components (stocks of raw materials, semi-finished and finished products, trade receivables from customers, trade payables to suppliers and other financial assets – such as cash, bank and other monetary assets). It should be noted that long-term financial requirements have to also include the minimum economic level of stocks of raw materials and products and some of the trade receivables from customers and liquidity, i.e. those assets that allow the company to carry out its business on a regular basis. Distinction between the durable and the temporary parts of the financial asset needs assumes great importance for the composition of an efficient FS which has to foster acquisition and repayments of financial means to avoid capital shortages or an excess of monetary availability. In other words, the choice of the financing sources, starting from their forecast, is a key factor to optimise the possibilities offered by the financial market according to the objectives of cost-effectiveness,

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homogeneity, flexibility and elasticity of financial management as a whole, bearing in mind, however, that the correlation between the length of investments and that of the financial sources is a key element. Within the various categories of sources, long-lasting financing needs should be covered by equity and long-term financing, while temporary needs should be covered by short-term financing.This statement is merely a generalisation, as it does not consider the variable conditions of money and financial markets on which the company actually negotiates its loans. The fact that needs can be characterised in relation to the duration and stability of the uses and sources of financing provides the chance to search for consistency between the time cycle of assets and liabilities (Brugger, 1982; Dallocchio & Salvi, 2011). This means that companies need to be able to have funds available when necessary and have a repayment plan in line with the final term of their needs. For example, a self-liquidating form of financing anchored to trade receivables makes it possible to respond to a seasonal expansion of needs; and again, a multi-year loan is suitable for financing and industrial plant, also with a multi-year duration, which will be subject to substantial amortisation in future years, and will result in a self-financing as the necessary flows to service the loan are derived from operational activity. These examples are not intended, however, to suggest a direct relationship between a financing and an investment. As confirmed by an influential research piece: …before entering into particular considerations regarding the convenient structure of company financing, it should be noted that this financing cannot be correctly judged from the point of view of their convenience with respect to the company, examining in isolation in their characteristics, individual needs for investment data and individual financing particularly suitable for them. Rather, it is necessary to consider, on the one hand, the complex structure of the company’s investments and the variability and other characteristics of the total capital requirements determined by them; on the other hand, the structure of the total financing realised or achievable by drawing on various sources and negotiating different conditions. (Onida, 1984). It is, in fact: …vain and misleading to consider in abstract isolation individual needs for given investment, both because each particular need may behave differently with others and contribute to determine the total need in its variability, as well as in its size, and because the individual investments that contribute to determine the financial needs could not be appreciated in the risk and in the related revenues, if not included in the complex structure of the simultaneous or subsequent investments of the company… Briefly, the financing provided to the

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Corporate Financial Distress company in various forms and under various conditions, constitutes a mobile mass that, as a whole, seeks, as far as possible, convenient adaptation to the changing complex of needs. Even when problems of financing arise during new particular investments (determined, for example, by a vast renovation of the plant), it is still the company in its complex management and therefore in the totality of its investments and passive financing, in its risks and in its profitability, which must be taken into consideration in order to correctly judge the convenience of the new financing in terms of size, form and every condition. (Onida, 1984).

4.2 Interdependence and Complementarity of the Company’s Different Sources of Financing As shown in the previous paragraphs, the combination of venture and credit capital is a complex process that requires an examination of the economic and financial management of the company. Financing, in fact, represents a fundamental moment in the life of a company that must be coordinated with all the other business issues. These are decisions of a comprehensive nature that have to consider all the circumstances that may lead to one or another solution, including the cost of financing, the risk and profitability factor, the interests of the economic entity, present and prospective situations, and the money and financial markets in which the company is present. In order to define the optimal FS of a company, its financial analysis is a fundamental support; this is carried out through a process of reclassification of the balance sheet into homogeneous categories representing the financial sources and their uses. Comparison of these categories reveals an opinion on the FS and on the actions aimed at conducting or maintaining the structure itself in conditions of equilibrium. The analysis is normally based on the equation: IN 1 S 1 FA 1 LA ¼ P 1 Dml 1 Db

where: IN 5 indicates tangible fixed assets (plant, machinery, land, buildings, etc.); S 5 represents stocks of raw materials, semi-finished and finished products net of adjustment items; FA 5 indicates financial assets without monetary function, represented by incomes originating from the production cycle and financial assets, such as securities, which do not express immediate purchasing power, a gain net of adjustment items; LA 5 represents assets with a monetary function (liquid assets), such as cash and bank deposits; P 5 indicates assets, i.e. permanent resources acquired with the restriction of risk capital, such as share capital, reserves, capitalised profits;

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Dml 5 corresponds to medium- and long-term debts, or consolidated debts, such as debentures or loans; Db 5 indicates formally short-term debts, such as loans granted by banks, or commitments to suppliers. The configuration that the FS may take on in the company’s operational combinations can be schematically summarised in one of the three alternatives set out below and represented in Fig. 1.2, Tables 1.1–1.2 (Monti & Messina, 1996). If the equity exceeds the value committed to the net fixed assets, the FS margin measures this difference given by the P 2 IN relationship. The existence of a structural margin, as illustrated in the figure, makes it possible to ensure that the share of long-term needs can be covered by assets. If the assets result less than the net fixed assets, but the permanent capital (consisting of assets and medium and long-term liabilities) still guarantees the coverage of fixed assets, the difference (P 1 Dml) 2 IN is defined as revolving fund. The revolving fund, or ‘working capital’, by virtue of the balance sheet constraint, is equal to net working capital (NWC), i.e. S 1 AF 1 AL 2 Db. The hypothesis of a positive revolving fund, such as the one under examination, implies that the company presents conditions of financial equilibrium all the same, even if this is only partial, due to the relative lack of assets, a circumstance highlighted by a negative margin structure (Caramiello, 1989) (Table 1.3).

Table 1.1. Positive Margin Structure Hypothesis. IN S 1 FA 1 LA

P Margin structure Dml 1 Db

Table 1.2. Hypothesis of Positive Revolving Fund. IN S 1 FA 1 LA

P 1 Dml Revolving fund with P , IN Db

Table 1.3. Assumptions of Negative Net Working Capital (NWC). IN S 1 AF 1 AL

P 1 Dml CCN , 0 Db

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Corporate Financial Distress

If the equity is lower than the value of tangible fixed assets, we will find both the higher amount of durable capital requirements compared to permanent loans, and the prevalence of short-term debts compared to gross working capital, being in this case S 1 F 1 AL , Db: this situation generates negative net working capital (CCN , 0). Under these conditions, short-term payables become essentially fixed due to the debtor company’s inability to reduce the volume of IN without stopping the production process.The company’s weaknesses can be solved by means of equity capital injections or by consolidating funds. A prerequisite for the manoeuvres in question is the availability of potential future assets.The potential for debt reduction depends on the management’s ability to generate profits and cash flow, a fundamental condition to eliminate the risk of insolvency. In fact, expected profitability is an irreplaceable source and prerequisite for the company’s selfreinforcement and affects the operating cash flows, which represent the critical element for the repayment of loans (Giovannini, 1983). The progressive deterioration in the relationship between financial requirements and sources, with the transition from a positive margin structure and revolving fund to a negative margin structure, up to a negative net working capital, corresponds to a proportional increase in the fixed assets of the loans drawn, regardless of their formal duration. Thus, there is a progressive involvement of the lender in the affairs of the entrusted company, a situation that does not fully manifest its effects as long as prospective profit conditions remain, but expresses its precariousness in full when these cease to exist. The decline in the company’s profitability makes it impossible for the firm to repay the borrowed capital and interests (Capaldo, 1967, 1968; Dallocchio & Salvi, 2011; Giannessi, 1982). In brief, therefore, the financial need of a company will be generated by the following components:

• •

purchase of production factors (real activities introduced in the production process); financial dynamics of the production cycle (liquidity and cash, financing receivables, etc.).

These capital requirements must be appropriately correlated with the financing sources to cope with the various operations in progress. The coverage methods depend essentially on the duration of the financial requirements: it is necessary that the nature of the time constraint of the capital flowing (risk capital, long-term financing capital, payment extensions, various facilities, bank credit, etc.) is always compatible with the dynamics of the financial maturities of the company’s activities. Finally, the optimal structure for linking sources and uses of financial resources requires that short-term indebtedness, which is, by definition, readily modifiable, should be available for temporary needs. On the other hand, longlasting needs are covered by assets and long-term debt (loans, bond issues, etc.). On the basis of the expected dynamics, on the one hand, of the needs and, on the other hand, of the conditions for acquiring financial resources, the possible

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alternatives in the company’s FS must be identified. Amongst these alternatives, the most convenient one must be chosen, taking into account the internal and external constraints imposed by the existing debt. Basically, it is a question of identifying the optimal ratio between credit capital and equity, the financial leverage or degree of ‘leverage’, i.e. external sources of financing and the weight of the various forms of funding offered by the market. As already pointed out, the cost of the various options, the market efficiency and the possible need to maintain control over the company are further elements affecting financial choices. In the operational reality, FSs may be identified that involve relatively low costs, but come with particular risks related to specific rigidities, such as the high probability of a sudden shortcoming of the very same sources. Other risks (and costs) may derive from the instability and defence of shareholding structures and, more generally, from the increasing difficulty of dilating the company’s ‘leverage’, together with more or less rapid and inevitable increases in capital requirements. Alternatively, there will be financing structures which, although relatively expensive, may offer advantages linked to a greater elasticity, or easier debt expansion without significant cost overruns, etc. Finally, attention must be paid to the problem of the optimal composition of credit/equity capital. Scholars differ in their preference for using one or the other for the financing of business management. The thesis that a convenient ‘leverage’ allows for an adequate increase in market value is adequately balanced by the contrary thesis (which gives preference to equity capital as the most appropriate means to maintain control over the company). Even the thesis put forward by Modigliani and Miller demonstrates that any difference – in market value – between two companies, identical in everything except for their level of ‘leverage’, is cancelled by the arbitrage of the shareholders, thus making no difference in the choice between equity and credit financing. Modigliani and Miller’s claim of ‘breakage’ is based on the consideration that, in a perfect capital market, the value of companies does not depend on their FS (Modigliani & Miller, 1958). The logical and mathematical path they followed is complex, so much so that, retrospectively, Modigliani stated that in fact this is a difficult article, which was not intended for students, but was originally written with the aim of putting our colleagues – from the corporate finance field – in crisis, showing them that what was considered the central problem of the discipline (what was the optimal distribution of sources of finance between venture capital and debt with a fixed remuneration) was actually a fake problem, since in principle, the financial structure made no difference (Modigliani, 1999). The traditional approach deals with the problem in terms of maximising the immediate profit, that is the explicit cost of the different sources of financing. The cost of debt, in terms of payable interest, is lower than the remuneration expected from shareholders and therefore, the obvious conclusion, at an immediate level, was that debt was cheaper than issuing new shares. This approach, however, did not take into account the fact that a rising indebtedness progressively increases the riskiness of equity, in which both profits and operating losses are included. This is reflected in return rates and results in higher costs.

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4.3 The Choice of the Most Convenient Financial Structure and ‘Leverage’ From the aforementioned considerations on the changing exogenous and endogenous corporate conditions which characterise the different and dynamic configuration of capital, it is clearly impossible to fix the optimal ratio between venture capital and loans to be valid for all companies regardless of their economic context. According to Brealey and Myers’ ‘third law’, no financial mathematical model is able to lead to a decision concerning the optimal ultimate Financial Structure (FS), given the complexity of the business reality and the imponderable factors that fall within the concept of financial planning (Brealey, Meyrs & Sandri, 2003). The same authors highlight, however, the importance of financial planning models which, on the basis of a set of more or less articulated assumptions, can help the search for the optimal FS. The models do not, however, define any absolute strategies but they put forward alternative scenarios, in relation to which the financial manager can evaluate risks and opportunities related to his own choices concerning financial balance. The ability to predict the evolution and keep the FS under control becomes, therefore, a key factor for the company’s safe development. When examining companies in crisis, one of the causes of the collapse is the excessive amount of credit capital which is by far more expensive than equity. The advantageous relationship between equity and debt is always to be carefully examined as well as all the previous statements concerning the optimal coverage of the company’s financial needs. Finally, the claim to be able to determine a single optimal ratio between capital of one form and the other for all companies must be considered completely useless. As a matter of fact, the relationship between debt and equity varies according to different companies, environments and different monetary and financial markets. In a very approximate way, it can be said that a company’s financial equilibrium should be based on the following basic conditions (Fogolin and Tavaglini, 2001):

• • • • • •

ability to plan and control monetary revenues and expenses; efficient management of the net working capital dynamics; endowment of a liability structure (coverage) fitting the characteristics of the net invested capital, with a correct balance between equity and debt capital; maintaining the average return on net invested capital above the weighted cost of equity; achieving the economic balance necessary to cover the financial charges; generating optimal cash flows to grant the company’s development.

It is, however, difficult to define an ideal path respecting all the conditions listed above. Only very infrequently will a company have a financial situation that meets all these requirements. Instead it will find the right balance between some of the above-mentioned variables and the other related issues. For these purposes, the study of the ‘leverage’ effect, highlighting the return on risk capital (ROI) in the event of an increase in the company’s debt, may be of help.

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19

For financial leverage we mean all the interventions aimed at controlling any change in the level of indebtedness to maintain it at the optimum level of profitability. The correct analysis of this ratio is important considering that every management choice affecting it produces some effects on the FS as a whole (Ferrero, 1982). The data underlying the financial and operating leverage are significant as they make it possible to assess the company’s economic performance in terms of elasticity and operational and strategic flexibility. The notion of leverage refers to the multiplicative effect on the company’s income that occurs when, in the presence of stable cost elements, different levels of profit can be obtained. The positive multiplicative effect occurs when funds, borrowed at a certain interest rate, are used in investments generating higher rates of return than the interest paid, so that the return on equity (ROE) grows as the debt index increases. Leverage is derived from the mathematical expression ROE (business profitability index) as a function of ROI (return on invested capital index), the debt index and the incidence rate of secondary management (which includes the financial charges incidence): ROE ¼ ROI 3

Ci Rn 3 Cp Ro

where: Rn 5 operating profit Ro 5 operating income of the ordinary operations The rate of return on new investments is equal to the increase in ROI. In other words, the rate of return on invested capital increases together with new investments, when these allow a more than proportional increase in the operating income. Thus, when the ROI is higher than the interest rate, the leverage operates in a favourable direction, i.e. debt helps to focus profitability on equity, and the return to shareholders (ROE) is higher as debt increases. When the ROI is lower than the interest rate, the leverage operates unfavourably because the cost of debt is higher than the return on assets. Financial leverage is, therefore, a synonym of risk, i.e. exposure to variability in a positive or negative sense, as it amplifies the impact of changes in the company’s typical operating situation on the ROE. The financial burden acts on the ROE; in fact, it changes according to any variation on the financing structure and it grows, with respect to ROI, in a proportion that will be examined further on. The ratio of elasticity assumes the following equation: LF ¼

Ro 2 OF 2 OF Ro

where: (Ro 2 OF) 5 RN 5 net result Ro 5 operational income of the ordinary operations; OF 5 represents the ‘financial charges’ actually paid to the credit capital.

20

Corporate Financial Distress

The degree of leverage (g), therefore, corresponds – in the first approximation – to the implicit ratio (Ro 2 OF)/Ro. With reference to the concept of ‘elasticity’, the quantity obtained is independent from the adopted unit of measurement, as only sheer ratios come into play. The use of elasticity allows for a better focus on the determinants of the phenomenon under observation, thus highlighting its conceptual architecture. It should still be noted that the leverage effect is proportional to the intensity of the degree of indebtedness d, i.e. the ratio between equity and debt capital: d ¼

Cc Cp

to the extent and sign of the difference between ROI and i: the calculation of financial charges, typically due to interest on debt, within the operating result, amplifies the profitability of equity compared to that the of invested capital. Consequently, the relationship between the two profitability configurations (ROI and ROE) and the related measurements can be expressed by the equation: ROE ¼ ROI 1 ðROI 2 iÞ 3

Cc Cp

which establishes the relationship (ROI 2i). Apparently, as mentioned above, the leverage effect is positive if ROI . i and negative if ROI , i. It is, finally, null if ROI 5 i. Some remarkable studies suggest a critique of the relationship between ‘i’ and ROI, observing that ‘i’ is not constant with respect to debt ratio, but it is an increasing function, as the ratio credit capital/equity capital increases. Moreover, they point out that the comparison under discussion is methodologically incorrect since ‘i’ is a monetary quantity, while ROI contains a real component, due to the fact that the operating income includes depreciation as well (Pivato, 1982). Of course, as in all leverages, there must be a fulcrum: it can be found in the expressions of the degree of leverage. In the financial leverage, the fulcrum is represented by the financial charges (OF) which, since they correspond to a remuneration freed from the company’s economic result paid out to the providers of the credit capital, have an impact on the ROE, i.e. on the remuneration of the holders of capital. The higher the debt ratio, the greater the leverage, keeping all other things equal, but the risk of a reduction in business activity has to be considered. Any entrepreneur who wants to maximise the leverage has to be aware of the level of risk and has to be ready to pay back the borrowed capital as debt matures. This last aspect may create some difficulties, since credit capital is often provided for short periods which do not cover the necessary time to amortise the investments. This can therefore lead to a situation where machinery needs to be financed by new equity and new credit capital. If possible, a choice should be made – within the credit bond financing – between short and medium (and long) term debt financing as the bank finances just businesses and not business operations; but it would also be wrong to forget that some investments raise particular financial needs, better satisfied by some sources than others. In business

Corporate Distress and Financial Equilibrium: Genesis and Prognosis

21

planning, the use of the concept of economic and financial leverage is very important whenever there is a need or opportunity both to estimate the behaviour of certain variables in response to the predetermined change of others, and to plan and then prepare the most appropriate structures in relation to presumable trends of those variables. In the former case, leverage plays the role of a useful tool in short-term planning: assuming one has some operating cost structures and forms of financing, the degree of leverage makes it possible to forecast, for a certain period of time, the influence that some alternative changes in sales revenues have on net profit. Leverage highlights both the height of the ‘multiplier’ to be applied to any change in operating profit, and obtain the change in net profit, and the degree of risk that the business owners bear in case of a reduction in operating profit. In long-term planning, economic leverage plays the role of a tool to measure the amount of risk that a given structure entails. It should be noted that this risk cannot be identified with a company’s economic risk because it is also affected by other factors such as:

• •

sales stability, as a result of monopolistic conditions; sales splitting: thus reducing the company’s dependence on third parties.

The use of financial instruments determining some fixed charges, independently from the operating result trend, makes it possible on the one hand to improve (if the results are good) the net result, and on the other hand, contributes to enhancing the negative effects of operations in the opposite case. These indications must be taken into account when adopting a structure involving some acceptable levels of risk. It is normal, therefore, that in business situations featuring high risks, associated with a given cost structure, financial architectures with a prevalence of equity are adopted. Having the possibility to choose among different financing sources, the company necessarily has to develop a ‘financial policy’ allowing the coordination of financing with the company’s general programme. The task of this policy is to provide the necessary funds within quantitative limits – constituted by the amount offered by the potential lenders – and the ‘price’ of these funds, and qualitative limits, represented by the constraints established by the legal system in force in that specific country. Normally it is neither possible nor appropriate to adopt a single source of financing, and so financial policy results in a difficult mix of credit constrained capital and self-financing equity. In the tradition of corporate financial theory, the issue of the optimal FS is intimately linked to the cost of capital, which cannot operate without reference to a given FS, whether retrospective or prospective. As universally acknowledged, Ke represents the return ‘due’ to the market as a consequence of the risk related to the equity investment. For example, if the increase in ROE was accompanied by an equal increase in Ke, as a result of an increase in financing liabilities, there would be no real benefit to the venture capital and therefore no increase in economic value. The opportunity cost of equity therefore serves as a benchmark to compare the profitability of risk capital,

22

Corporate Financial Distress

as a ‘minimum threshold’ to assess, ex-ante and ex-post, the investment and the financing alternatives. To identify the size of ‘satisfactory profitability’, the risk component has to be expressed as ‘objectively’ as possible: Ke, in fact, is influenced by financial risk, which, in turn, depends on the degree of indebtedness. For the shareholder, the company represents a capital investment, and its value coincides with the amount of capital employed if the expected return is equal to the one required by the market for alternative investments having the same degree of risk. In particular, it is clear that:

• • •

if ROE 5 Ke, the value of the capital coincides with the invested amount. This is the case, for example, of the investment in government bonds: the investor renounces the possibility to create value (i.e. to earn more than ‘due’) in order not to destroy value (i.e. to earn less than ‘due’); if ROE . Ke, the value spread is positive, i.e. the value of the capital is higher than the invested amount; if ROE , Ke, the expected profitability does not reach the return required by the market: it will result in value destruction.

It follows that the differential between profitability and cost of equity is fundamental to conduct any evaluation, when planning development and controlling performance, on the creation or destruction of value in financial and real policies. In opposition to what is stated here, it is worth remembering that according to the well-known Modigliani and Miller Theory, in a perfect capital market, the only variables generating value are the future income capacity and the risk-return binomial of the company’s activity, or the initiatives affecting the balance sheet and not the combination of the financing sources. According to the second proposition of this theory, a greater recourse to debt equally affects the ROE and the cost of equity (Ke), so as to leave the health of venture capital investors unvaried (Modigliani & Miller, 1958). Corporate governance activities intended to drive higher rates of ROE by exploiting leverage, but which are accompanied by increasing financial risk, can cause value destruction when the increase in risk outweighs the ROE. Considering what has been stated above, the analysis of the company’s financial situation, both current and future, becomes an essential step in determining the optimal FS. While examining the value of the choices of capital management, related to the determination of macro-financing sources, as part of the process of optimising the FS, it is necessary to consider that the company, in relation to its planned development dynamics, is compelled to face a complex of qualitative–quantitative risks.

4.4 Assessment of the Financial Equilibrium According to the approaches suggested by corporate finance, a company reaches a financial balance when it achieves all, or some of the following characteristics: it

Corporate Distress and Financial Equilibrium: Genesis and Prognosis

23

controls, in the short term, the gap between monetary income and expenditure; it shows a FS (composition of liabilities) consistent with the pursued strategy; it shows some working capital dynamics well connected with the turnover evolution; it has a correct ratio between operating income and financial charges, also considering the possible prospective dynamics linked to the conditions of operating and financial risk; it has a correct ratio between the economic value of assets and the value of liabilities; it has an acceptable/optimal relationship between the overall cash flow and the company development; it has a FS maximising the value of the company. By definition, financial balance depends on the period of time to which it refers; in concrete terms, therefore, it can be considered separately with either reference to the short term (liquidity situation), or to the medium/long term (equity situation) (Dallocchio & Salvi, 2011; Pavarani, 2006). Short-term financial equilibrium has to be a constant feature throughout the whole company life, and its absence, if not immediately remedied, determines the inability to meet current liabilities and therefore the company’s insolvency and ultimate termination. The medium/long-term perspective analysis (made without taking into account any new management operations, subsequent to the analysis date) shows the existence of money outflows in advance over time. A balanced FS results in a surplus of permanent capital over fixed assets with stable long-term needs which would give the company an adequate strategic financial flexibility (Cavalieri & Ferraris-Franceschi, 2010). Regarding sources of financing, these can be divided into obligations, arising from normal operating activities (current liabilities), and obligations related to the raising of financial resources, whether owned or held by third parties. Net working capital is determined by subtracting the value of current liabilities from the value of the gross working capital. A further important component is self-financing, assumed in a broad sense as the difference between revenues related to income and expenses related to the costs of manufacturing items associated to the production sold in a certain period. In fact, the financial resources generated by revenues deriving from the consumption of simple factors used for the sold production, should be, at least in part, immediately re-used in the acquisition of factors of the same kind, so as to maintain a constant level of operating activity. Self-financing also consists of a monetary component, i.e. the difference between revenues and monetised costs during the period. It should be noted that self-generated equity, through self-financing, improves the structure and the degree of the company’s financial autonomy, leading to an increase in investment, more than proportional to financing, or to a decrease in the use of financial sources. These improvements will be durable for the part corresponding to the profits to be allocated as reserve. In general, an increase in net working capital, through the resources freed up by the recovery of investments in the production structure, should lead to an increase in the operational activity of the company or, in any case, to a reduction in its dependence on external support.

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Chapter 2

Corporate Recovery Plans between Value Protection and Management Turnaround 1. Corporate Financial Distress and Continuity: The Protection of Business Value. National, Economic and Legal Dimensions Corporate crisis, which originates mainly in incorrect strategic and operational management, appears as an economic–financial imbalance that sometimes lasts over time and ultimately becomes incurable (Falini, 2011), but that is also possible to resolve, by ‘recovering’ a stable equilibrium condition (the so-called turnaround). The evolution of the economic context has raised awareness of the negative consequences that can result from the dissolution of a company, both at an economic and at a social level. In a difficult economic context like the one experienced in recent years, which is likely to continue due to the effects of the COVID-19 pandemic, with a growing number of businesses in crisis, the importance of corporate restructuring operations significantly increases. Restructuring has to be considered a physiological phase in the company life cycle and, as such, has to be managed by optimising all the existing resources, with the aim of leading the company towards stabilisation, growth and value creation. The starting assumption is that no crisis is intrinsically unrecoverable: the problem is not the existence of a solution to the crisis itself, but rather the economic convenience and willingness of the actors involved in the recovery to provide the necessary means for the successful achievement of equilibrium conditions. The choice of the solution for overcoming a corporate crisis has not only to consider the degree of intensity but also needs to consider relationships with external stakeholders. In literature, it has been observed that the link between corporate governance and the governance of strategic dynamics on the one hand, and crisis situations on the other, is extremely strong and finds its key expression in recovery strategies.

Corporate Financial Distress, 25–50 Copyright © 2021 by Emerald Publishing Limited All rights of reproduction in any form reserved doi:10.1108/978-1-83982-980-220211003

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Indeed, the corporate crisis concept directly refers to the necessity to proceed strategically (Guatri, 1995; Galeotti, 2008). Any crisis management tool should allow for the regulation of some aspects which are common to all crises such as:

• • • • • •

the creditors’ right to obtain a repayment of their claims; the interest of several stakeholders, primarily employees, to continue the business; the community right to a correct allocation of all the resources employed in the corporate restructuring; the cost-effectiveness (or overall convenience) of the crisis management; the promotion of virtuous behaviour and, if possible, of predictive scenarios, thus avoiding moral hazard phenomena; the closure of companies whose recovery is not achievable.

Suitable tools to solve a corporate crisis have to reconcile the efficiency principle (and, therefore, the lower cost of management) and that of equity (that is, the maximum satisfaction of stakeholders) to avoid failure (Lacchini, 1998). The principle of efficiency in protecting the value of a company implies that the treatment of the crisis must avoid all unnecessary value destruction; this is the criterion which should always lead the choice between liquidation and continuity. Interventions pursuing company recovery are obviously possible at any stage of the crisis but, as it worsens, their chance of success decreases while their complexity increases. In Italy, crisis management tools impose the concept of fairness through two established principles: the par condicio creditorum and the absolute priority rule. Equal treatment among all creditors must be applied, in compliance with the preemption right (the so-called seniority). The equity requirement concerns the definition of the correct mechanisms of participation in the company’s operating or liquidation value, and directly affects the expected level of losses absorbed by the various alternatives. It has to be noted that – if it can be demonstrated that the economic flows which can be generated in future by the company will be higher than those obtainable at the outcome of its liquidation – the company value will certainly be greater in the case of continuation than that of liquidation. Probably, these cash flows will be achievable by debt restructuring, if necessary, or by injecting any additional capital resources, but even more certainly, by resetting the ‘business model’ and by submitting the company management to a strict oversight. The management must prove it is able to recover income and demonstrate the financial ability to honour, at least partially, the existing debts. Any additional financial resources, or reduced or cancelled liabilities (also noteworthy ones), will never be able, on their own, to recreate the conditions of economy and corporate sustainability in the absence of a credible strategy and of a completely revised organisation.

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27

The ‘business model’ is made up of four interconnected key elements which, taken together, create and provide value. They are: (1) the customer value proposition; (2) the profit formula (articulated in: the revenue model, cost structure, margin model, rotation speed of resources, etc.); (3) key resources (people, technology, products, structures, equipment, etc.); (4) the key processes (training, development, production, accounting and budgeting, sales and services, etc.). These four elements represent the milestones of any business. The strength of this pattern resides in the complex interdependence of its parts; successful companies create a more or less stable system, within which all these elements are connected in a coherent and complementary way. A company in crisis will have to deeply review its ‘business model’ by analysing and getting a diagnosis of its competitive situation, in terms of market, product and process technology, strategies and of its own organisation. The latitude and longitude of any intervention to be carried out within the company (or the group of companies) will only take place after a sound audit which will identify the needs of innovation, even when latent. With a view to the creditors’ satisfaction, the recovery will present itself as a potentially preferable alternative to liquidation, whenever VC > VL (where VC represents the value of creditors’ satisfaction with business continuity and VL the value of creditors’ satisfaction in case of liquidation which would be equal to the adjusted assets minus the costs of liquidation). As indicated by the corporate literature (Tiscini, 2014; Tron, 2016), the company value – in the business recovery scenario – can be expressed as follows: r21

VC ¼ +t ¼ 0

CFt CFt CFSt CPt n ‘ r 1 +t ¼ r 1 +t ¼ n 1 1 2 +t ¼ 0 ð1 1 iÞt ð1 1 iÞt ð1 1 iÞt ð1 1 iÞt

where: n is the analytical forecast horizon of the business plan; r is the time horizon of the recovery, necessary for the recovery of the economic equilibrium condition; CF is the operating cash flow generated by the company in each financial year; CFS is the stabilised operating cash flow that can be generated in the period following the analytical forecast horizon; CP is the cost of the arrangement procedure for each financial year of its duration; I is the discount rate of continuity cash flows. Assuming that the value of self-realisation of corporate assets does not change in the recovery horizon ‘r’, the first term of the expression represents the p component (under-remuneration during the renovation), the second and third the AR 1 GW component (value of the rehabilitated company) and the fourth the CP component (costs of the procedure).

28

Corporate Financial Distress Similarly, the value extractable from liquidation can be expressed as follows: 1

VL ¼ +t ¼ 0

VRAt CLt 1 2 +t ¼ 0 ð1 1 i9Þt ð1 1 i9Þt

where:

• • • •

l is the time horizon necessary for the liquidation of the assets; VRA is the value of the realisable assets that can be liquidated in each year; CL is the cost of the liquidation procedure charged to each year; i9 is the discounted rate of liquidation cash flows.

The first term of the expression corresponds to AR (active achievable) and the second to CL (cost of the liquidation procedure). The company value in continuity is, in fact, the value destined for the creditors’ satisfaction, in the scenario of continuity. The recovery proposal can, however, predict values which are lower than the aforementioned one. Whenever the value obtainable from business continuity (aimed at the preservation of the company) is greater than the corresponding value retractable from the liquidation of the assets, the recovery path should, in principle, be chosen without any hesitation. This evaluation has to be carried out also in the case of transfer of the whole business, especially where more favourable conditions (and, consequently, a higher business value) have been recreated through the going concern. It is a widespread opinion in the economic–corporate and legal literature that private renegotiation, when promptly implemented, is the most suitable response to a company crisis, even just considering the inefficiency in direct and indirect costs connected to bankruptcy procedures and their (not always favourable) outcomes for creditors (Danovi, 2014; Ambrosini, 2013). Saving the company and its intrinsic value, where possible, frequently leads to much more satisfactory results, both in terms of efficiency and of satisfaction of the credit class, than those reachable at the outcome of a bankruptcy proceeding. An insolvency management system is envisaged, albeit with inevitable specificities, in most systems of both civil and common law, since the main problem that the company in crisis represents is the reconciliation of the different needs of the stakeholders involved. These are often antithetical to each other, and a hierarchy needs to be established in terms of their priority. For these reasons, in recent years increasing attention has been paid to corporate crisis management systems, i.e. institutional mechanisms (regulated by law or entrusted to the free initiative of the parties) of insolvency management, able to operate increasingly closer to market rules. The above considerations have led some scholars to seek alternative and more effective solutions to overcoming business crises and accordingly, to urge legislators to modify the existing norms accordingly. Deep dissatisfaction had in fact arisen over the outcomes of legislative approaches to solving corporate crises before bankruptcy law reform took place.

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Bankruptcy procedures, as applied until 2005, lasted a long time but had low profitability in practice. Indeed, the costs of the procedures themselves absorbed most of the profits from the sale of the companies’ assets. The conservation and liquidation costs of the assets, as well as those related to the compensation fees for the administrator and their team, had a significant impact. But that is not all. The situation was made even more serious due to the long times normally necessary for the effective sale of the bankruptcy assets and moreover: …all the experience of the last twenty years brought to the attention of commercial law scholars the phenomenon of extrajudicial settlement agreements of business crises and, among these, in particular, those that contemplate the rescue of the company in order to allow the continuation of the activity (Boggio, 2007). Furthermore, the analyses of the economic and financial matrix revealed: …the inefficiency of the insolvency procedures in Italy, with reference to the destiny of the company, to the percentages of realisation of the assets and satisfaction of creditors, at their times and costs (Lacchini, 1998). Some reflections in the literature and some decisions in insolvency proceedings under bankruptcy law call for better consideration of the more general economic conditions of the company and also of the value of company assets even when determined at immediately realisable prices. This hypothesis is valid also in the case that the active company has been sold and more favourable conditions (and a higher corporate value) have been recreated for the business owner. This, and other reasons, led scholars to highlight the need to set up an insolvency management system able to minimise the risk of:

• • •

liquidation of businesses for which there are well-founded prospects for recovery (and of value improvement) and that are therefore worthy of being kept in operation; allowing the continuation of businesses that would provoke the destruction of further wealth and which are proven to more valuable if dissolved; not adopting the plan that best maximises the company value, especially in the case of continuation of the company activity.

To achieve these goals, national literature studies in the various reform projects concluded that promoting agreements between creditors and debtors should be a primary means for resolving crises. The liquidation procedure is then limited to a measure applied only in the case of failure to reach a settlement between creditors and debtors (Di Marzio, 2010).

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Corporate Financial Distress

As a consequence, negotiated agreements were considered as potential tools to solve business crises, or as a measure to support other insolvency procedures. The negotiable component of the crisis is based on the assumption of a reasonable prospect that the crisis can be reversed but also of a liquidation as an alternative to the opening of a bankruptcy procedure. Extra-judicial crisis management is founded on the following assumptions:

•

• • •

the economic entity of the company in crisis and its major creditors(usually banks, who are by far the most exposed creditors) verify the possibility of a general agreement within the credit class, to avoid the formal declaration of a state of insolvency and the subsequent opening of a bankruptcy procedure; the company and the creditors, at this point, have a restructuring plan worked out and eventually offers creditors some guarantees; on the basis of this plan – usually with the help of an advisor – an ‘agreement’ is elaborated and it includes a series of financial measures (through some projections, the conditions of the original debts are rescheduled to make them compatible with the company’s capacity to generate future cash flows); the agreement is then submitted to the credit class and approved (and binding) if it obtains a pre-established percentage of consensus.

Out-of-court solutions to business crises are therefore focused on private renegotiation of indebtedness, which leeds to the signing of special agreements with banks and commercial creditors (Sirleo, 2009). This results in a flexible system, allowing the parties to develop alternative solutions to bankruptcy whether that is the desire of debtors or creditors, and as long as the parties involved have some desirable features, also based on other aspects (Belcredi, 1995). The out-of-court agreement is generally considered easier since:

• • • •

it should avoid the risk of inefficient liquidation, i.e. the closure of a company whose operating value is higher than the one obtained by liquidation; it should allow higher debt recovery rates than those obtainable in case of insolvency procedures; it should be more allocatively efficient (as the company, during the renegotiation process, continues to be managed by a specialised management) and operational (due to its more limited cost impact); it should be adaptable to the specificity of each individual case.

The trend of out-of-court settlements of business crises presents a few problems, however: (1) the high number of individuals involved in the operations; (2) the peculiarity of the interests pursued by each party; (3) the development of the recovery plan which has to meet the expectations of different stakeholders.

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Among the factors which may constitute a drawback to the out-of-court solution to the business crisis, the operationally more complex one appears to be the coordination of creditors, who have the power to decide whether the company can continue its activity or has to be subjected to a bankruptcy procedure. Another problematic area is the frequent need to provide new financial resources to the company to allow restructuring and reinvigoration. If, as often happens, the old ownership is unable to provide additional financial means (in whole or in part) and the search for a possible industrial partner is particularly difficult, banks are called on to bear the burden of the ‘new finance’ supply. Other problems may arise due to a potential delay in the launch of the operations forecast in the ‘plan’ and due to difficulties in controlling its correct and timely execution. Further on, the main risk comes from the failure to coordinate creditors and the pursuit, by some of them, of personal goals which do not represent any category interest (Sirleo, 2009). In fact, the proposal to creditors, even if only bankers, is frequently examined and approved on the basis of considerations which are not always technical, but relate to the individual creditor’s sheer convenience. The effect of this behaviour is that the most exposed banks have, in this case, to take on the company’s debt towards creditors and non-member banks. Moreover, the creditors’ response of acceptance, whether positive or negative, may be late to arrive. In practice, most of the answers from creditors come when the opportunities on which the plan was based have already vanished or have become much more expensive to pursue. If the plan is finally approved and made valid in the so-called ‘agreement’, the assessment of its effective and timely execution is entrusted to a ‘leading’ bank or to a committee of banks (the so-called surveillance): but guidelines and operational decisions are difficult to have from these actors as they risk, in the event of a future filing for bankruptcy, to be considered – by the liquidator – as sort of ‘de facto’ company managers. Despite the above considerations, it is a widespread opinion, both in literature and in the best practice, that private renegotiation is the most suitable answer to business crises as it avoids direct and indirect inefficiency costs and promotes an agreeable outcome for creditors, which might not be obtained under bankruptcy procedures. Safeguarding the company, and its intrinsic value, therefore, makes it possible to achieve – in most cases – incomparably better results than those that can be reached in a bankruptcy proceeding. Furthermore, extrajudicial renegotiation presents a multiplicity of possible configurations, based on the different types of companies involved, thus constituting a flexible tool which allows the entrepreneur to try alternative solutions to bankruptcy, both through the restructuring of liabilities and through the preparation of a turnaround plan. Out-of-court agreements can lead all stakeholders to more satisfactory results, both in terms of flexibility, since they are only partially bound by strict procedural rules, and in terms of time and economic efficiency.

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Corporate Financial Distress Authoritative scholars affirm that: …even in the presence of this variety, it is possible to trace some common elements, characteristic of all successful cases. For example, the following initial conditions are generally recurrent: one insolvency situation of negative equity, only in part notified to external operators; the presence of a high indebtedness level, principally towards the banking system; a third party’s interest in the company (or at least, in part of it) as it is still considered potentially valid on an industrial level; the existence of reasons which also induce creditors to prefer alternative solutions to a bankruptcy procedure. (Danovi, 2003)

The greater efficiency of the selected instrument will be related to the possibility to guarantee the business continuity: only in this case, the related intangible values connected to the company organisation and functioning will be preserved. In the event of a bankruptcy proceeding, they would inevitably be dispersed. In this respect, the agreement with creditors is to be considered an atypical contract pursuing the goal, on the one hand, of the conservation of the company and, on the other, of the implementation of agreements relating to individual members (Sirleo, 2009). The main advantage of this type of arrangement is the non-invasive presence of forecasts which limit its contents. Parties begin to write down the plan, and the underlying agreement with creditors, in the way they consider more convenient, by indicating the percentages, methods, contents and objectives while making sure to adapt each recovery project to the characteristics and possibilities of the participants, as well as to the conditions of the market on which the company operates. Over the years it has been observed that by avoiding invasive judicial control during the recovery phase, the resources needed to satisfy creditors are allowed to act freely, more quickly and with greater results (Giuliano & Di Gravio, 2005). The Italian Stock Exchange (BorsaItaliana) has defined the Business Plan Guidelines that can be considered as a first benchmark to be followed for the recovery business plan drafting as shown in Table 2.1.

2. The Feasibility of a Recovery Business Plan: Best Practice Principles (CNDCEC) For the negotiation of the crisis business plan, the restructuring or industrial/ strategic turnaround assumes a role of absolute pre-eminence as an essential complement to any considerations of a financial and corporate nature. To this end, the entrepreneur is required to draw up an adequate and consistent turnaround plan, or reorganisation. The plan represents the essential tool to evaluate the technical and economic feasibility of the overall recovery project. All the measures deemed necessary to solve the crisis and the implementation schedule must be included in the plan. Furthermore, the plan has to

Table 2.1. Italian Stock Exchange (Borsa Italiana) Business Plan Guidelines. Yesterday Today Strategy Implemented

Strategic Plans

Action Plan

Hypothesis

Financial Data Forecast

Management decisions: N Role of the competitive area N Value proposition N Creation of the competitive advantage How we intend to create value Eva

Actions that reduce the gap between implemented strategic plan. In particular: N Economic/financial impact and timing N Investments to make N Organisational impact of the individual actions N Intervention on the services/brand products portfolio N Actions that change target customers N Responsible Managers N Conditions and feasibility constraints

Related to key value drivers and prospective data with reference of: N Macroeconomic quantities N Revenue development N Direct costs N Indirect costs, financial charges, tax N Capital employed trend N Financial structure trend

Consistent with the strategic plan and Action plan and with reference to: N Business Units N Distribution channels N Geographical areas N Type on customers N Products/Services/ Brand

Source: Adapted from Italian Stock Exchange (BorsaItaliana), Business Plan Guidelines, 2003.

Corporate Recovery Plans

Description of N Strategic approach N Performance achieved in each business unit N Strategic renewal needs/opportunities Illustration of the origins and conditions of the strategic plan Sector QMAT

Tomorrow

33

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Corporate Financial Distress

respect the principles of clarity, completeness, reliability, neutrality, transparency and prudence so as to allow the company, and the third parties, to be able to appreciate its correctness and take their necessary decisions. A document drawn up in 2017 by the National Council of Chartered Accountants and Accounting Experts (CNDCEC with AIDEA-ANDAF-APRIOCRI) entitled Guidelines for the preparation of the Recovery Business Plan (hereafter Principi) highlights how the basic aim is to rationalise and plan the business choices and summarise them in a complete document, which should be representative and easy to read. If the Recovery Business Plan (hereafter ‘RBP’) respects the principle of clarity, the recipient will immediately understand the business idea underlying it, the subsequent objectives, the tools and solutions to achieve it and the resources to be used. The completeness principle implies the inclusion of any information deemed relevant for the effective and thorough understanding of the project to which the forecast document refers. The completeness principle should be combined with that of clarity and developed according to conceptual needs. In the case of startups, the description of the company’s history relies on the understanding of the relevant qualifications of the promoters and their respective ability or potential. The principles of reliability and consistency imply that the RBP has to be correct and adequate: is means that the assumptions and procedures – through which the formulation of the projections and the derivation of conclusions takes place – are reliable. The reliability of the RBP must be realised and tested in advance, by identifying the type and use of qualified resources, whose combination defines the production process. The neutrality principle indicates that the document should be drawn up with criteria that are as objective and accurately weighted as possible, and that it should not be influenced by undeclared purposes that the author or the client intends to pursue. Transparency means that it must be possible to trace back any single statement or elaboration in the plan – from the summary result to the single element of analysis – and any source of data must be identifiable. Finally, the principle of prudence establishes that the assumptions underlying the RBP must represent the most likely scenarios and, of course, the RBP has to consider the scenario evolution over at least three years. In the event of two or more alternative scenarios having the same probability of realisation, it is necessary to adopt the one which provides – in economic terms – lower revenues and/or higher costs or – in financial terms – a higher debt exposure. As an initial and preparatory activity for the RBP, the nature, objectives and essential characteristics of the recovery business project to which it refers have to be concisely declared. These include the elements of judgement regarding the planned initiative, the type and destination of the document, and finally the people involved in the initiative in different functions and roles. They all have to be explicitly identified in the subsequent planning and evaluation document. This statement is preliminary to the RBP operational drafting, in the sense that it has to be carried out before any analysis phase and development of the forecast document.

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Therefore, this statement has to be included in the initial part of the process (conception and preparation of the recovery business feasibility plan) but also in the final consultation and evaluation process and should be easy to consult by any of the possible recipients of the RBP. The author should be allowed to acquire an initial overall vision of the project to which the RBP refers, facilitating the elaboration of considerations of a more analytical, specific and detailed nature (CNDCEC, 2017). Alongside support in the decision-making process for a company, a wellformalised RBP provides a helpful structure and defines a working method; for the management from the overall activity to the guidelines for daily events. Furthermore, the RBP gives reference parameters, indicating the limits and objectives to measure the actual performances. If the parameters happen to be disregarded or overcome, there will always be the possibility to amend the RBP, the strategy or sometimes the objectives themselves. The RBP is vital for carrying on the core business: it is not used to predict, but to guide and outline the way to the final destination. Despite the importance of this internal purpose, the RBP is essentially created to communicate the objectives and present the project to a series of potential external interlocutors. The communication objectives of the RBP change according to the different phases of corporate life and to the type of recipients to whom the plan is addressed. It is good to point out from the start that the time component is often binding. The company will in fact have to face a difficult situation in which it can rely only on limited autonomous financial sources with respect to the commitments of payment. In the recovery operation (and in the related summary RBP), the company deals with a plurality of interlocutors, including banks, and consequently the decision-making processes require a longer time, far longer than the intervention time requirements of the RBP. The starting situation is of particular importance for the successful performance of the recovery plan or turnaround process. A deep and critical analysis of the company must therefore be carried out to redefine the strategies and identify the remediation actions. This analysis should highlight the causes of the corporate crisis, specifying whether it is an economic, financial or an economic–financial crisis. Once the causes of the crisis have been outlined and identified by various methodologies and applications, the business owner should quickly establish the guidelines for the recovery plan. A possible methodology involves carrying out a qualitative analysis of the company, by considering its status and competitive positioning on the market: the analysis will be realised by indices and by balance sheet flows over the previous three/five years. A first quantitative analysis can be carried out by the reclassification of the income statement and balance sheet data at the moment of the plan drafting. A method to reclassify the balance sheet data may be the financial criterion, in order to identify the times in which the investments will turn into liquidity, while the elements of the liabilities may be classified according to the collectability criterion. This type of balance sheet reclassification allows for the analysis of the short-term financial structure and balance.

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Corporate Financial Distress

The economic situation may be reclassified to allow for the identification of all the individual areas of income creation, that is the ordinary activity area and the extraordinary area. The re-elaborated income statement may allow some assumptions on the prospective ability to generate income, particularly the income generated by the operational management on which the recovery or turnaround plan will be based. With this in mind, the document must report the necessary measures to restore the economic management of the company, the debt settlement, the contextual resolution of financial problems, and finally the finding of new capital sources to bring the company back to its normal economic conditions (Onida, 1971). In order to improve the company’s economic and financial management, cash flows need to be optimised: that economic availability is absolutely necessary to relaunch the company. Authoritative literature claims that it is a question of reversing the presumed current inability of the operational management cash flows to ensure coverage of financial management flows and, at the same time, to leave a residual cash flow available to meet the remuneration expectations of shareholders and to attempt to bring the company back to positive profitability (Lacchini, 1998). Consequently, the RBP must be drawn up by taking into account the relaunch strategy that the business owner intends to implement, the environmental situations in which the company operates and the planned corporate restructuring (both ‘internal’ and ‘external’) operations. In particular, the ‘internal’ operations are all those activities on the company structure, such as, for example, the reduction of human resources, the rationalisation of the management, etc. The areas to act upon are those where inefficiency is evident or those which have to be created for the correct performance of the company. It will therefore be necessary to verify, for example, that:

• • •

there are systematic and reliable flows of information (budgets, cash flows, and so on); the marketing area is aware of market trends and competition; the sales area is ahead with respect of the evolution of demand and of customer needs (even potential ones).

Once the areas of intervention have been identified, priorities must be assigned. In particular, it is necessary to check which are the areas where no (or modest) investments are required. These may be prioritised, since they do not involve the use of any significant resources. As part of the ‘internal’ operations, the recovery plan has to contain one or more alternative strategies to be used in case of deviation from the hypotheses on which the plan is based. All the advantages and disadvantages of an intervention must be examined, and costs and returns have to be considered, also with reference to other equivalent actions. Among the alternative projects, a so-called ‘pessimistic’ (worst case) project shall be forecast, in case all the basic assumptions should fail.

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If the company crisis also creates a sales crash, with the consequence that the company structure goes into overstaffing, the problem of reducing the employee burden will arise. This reduction may take place through the use of the Ordinary Redundancy Fund, the Extraordinary Fund or the redundancy-related benefits schemes. In addition to the reduction of human resources, the recovery or turnaround plan may take into consideration the possibility of externalising some activities with the exclusive aim of improving the economic–financial situation and making production processes more efficient. The ‘external’ operations, on the other hand, concern the dismissal of parts of the business complex, such as the business units, or, the sale of investments which are not strategic for the achievement of the recovery plan – which is mainly focused on the company core business (Superti Furga, 1986). These operations are meant to supply financial sources and adequately support the recovery plan. Among the main financing sources to consider, we shall include:

• •

the contribution of risk capital, useful to demonstrate the credibility of the plan itself; the dismissal of non-strategic assets, useful to raise significant sums through the sale of assets or company branches which are not necessary for the recovery and the ongoing concern (the company core business as identified in the plan).

The RBP will then contain a series of indications relating to the economic, income and financial perspectives of the restructured company to be able to face the crisis, relaunch the business and achieve business efficiency again in a reasonably short time. While drafting the business plan, creditors should be motivated in a reliable and reasonable way to convince them that the negotiating solution is functional to the business recovery; for this purpose, it will be necessary to analytically indicate how the company will be reorganised.

3. Turnaround Strategy of a Financially Distressed Company Companies in financial distress should act on several fronts, and namely they have to:

• • • • •

make drastic operational management choices; make financial choices, in particular the renegotiation of onerous debts, without excluding new capital injections; put individual assets into liquidation, especially those not related to ordinary operations; implement a ‘recovery plan’, provided there are serious grounds for relaunching the business; allow for a partial or total transfer of the company (Pedrinola, 2007).

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Corporate Financial Distress

The entrepreneurial choice has to necessarily fall on the alternative that presents the least burden in terms of difference between the company value during the crisis and the value obtained as a result of any single choice (Prosperi, 2003). The recovery process has to lead to the definition of the best possible restructuring, once the economic viability of the company has been restored. The turnaround process should be activated before the crisis or once the basic conditions of economic viability have to be re-established. The recovery process (and related industrial and financial turnaround), on the other hand, occurs when the crisis has been acknowledged and is generally characterised by the presence of symptoms of absolute emergency. In both cases, in the perspective of bringing the company back to the market, a timely perception of the state of crisis is fundamental, and it implies a sensitive and critical analysis of all the causes which have determined the situation (and the state of alert). In the event of financial distress, the company will have to launch some recovery plans to restructure its debts towards the banking system and other creditors. The close dependence of the financial structure on the company operational setting requires an extraordinary business plan (RBP) to form assumptions and verify the possibility to generate cash flows functional to debt repayment. The recovery process, in this case, will consist of the following phases:

• • •

verification of the possibility of agreement between the company and all the main creditors (usually the banks) to avoid a formal declaration of insolvency; the company prepares, possibly with the help of a business consultant, a business plan that includes the possibility of its recovery, by granting some solid guarantees to creditors; on the basis of the business plan, a financial plan is prepared, with the assistance of an independent consultant. The financial plan will be based on the hypothesis of renegotiating the company’s debt and making it consistent with future cash flows.

With reference to the business plan, it will be necessary to immediately relaunch the company through a series of different actions:

•

•

an intervention of an industrial nature which will involve the possibility of producing and placing new products on the market to expand the product range (product innovation) and, at the same time or alternatively, the need to re-engineer the production processes to make them as efficient as possible (process innovation) with a reduction of costs per product; a managerial intervention which will focus on cost reduction, thus minimising the need for new finance. A deep analysis of the company organisation has to be carried out to verify the possibility of reducing any redundant staff and labour costs. This reduction can be implemented through the use of

Corporate Recovery Plans

•

39

redundancy fund procedures (in the two forms: ordinary and extraordinary) or by placing people in redundancy-related benefits schemes. By way of example, if it is assumed that the reduction in the company’s sales will be of short duration, since the decline in markets does not depend on a lack of competitiveness, recourse may be made to the ordinary redundancy fund. If staff reduction needs to be stable, as the crisis is a structural one, but at the same time, a sound reorganisation to face new challenges is being carried out, recourse can be made to the extraordinary redundancy fund. If, on the other hand, while implementing a structural reorganisation, it is not expected that the company’s activities will recover and previously employed staff can be reabsorbed, then recourse will be made to redundancy-related benefits schemes; an intervention of a financial nature, which will cover the new investments necessary for the recovery. Investments will concern both tangible and intangible assets useful for the product and/or for process innovation as foreseen in the recovery plan. These investments will come, as far as possible, from sources which are not onerous (risk capital, in order to demonstrate the credibility of the economic entity that means to carry out the recovery plan) and from onerous sources (credit capital, very difficult to obtain in situations of business crisis). An alternative to the non-onerous source (equity capital) may be represented by the sale of non-strategic assets.

The process of removing and overcoming the crisis (the so-called turnaround) will then be in the form of a financial plan (turnaround plan) which will restore the company’s economic and financial balance in a reasonable time frame. Corporate economic literature has recently stated that the expression ‘turnaround’, of Anglo-Saxon origin, refers to all the systematic processes of recovery and relaunch of companies in crisis. In order to fully understand this term, and therefore the size and incisiveness of the measures necessary to overcome the crisis, it will be necessary to dwell on the concept of crisis from a ‘dynamictemporal’ point of view. We have to make a clear distinction between the real crisis and the concept of decline. Crisis may be a phase (or ‘stage’) in the company life cycle whereas decline emphasises an irreversible situation of difficulty (Aloi, 2004; Bertoli, 2000; Danovi, 2003; Guatri, 1995; Pollio, 2009; Rossi, 2003; Tami, 2002). All the changes adopted by a turnaround strategy often have homogeneous characteristics such as the timeliness and urgency with which they must be implemented, their invasiveness, the involvement of all stakeholders and the pursuit of economic and financial balance (return to value) oriented to the long term. The preparatory measures for the formulation of the recovery plan consist of immediate steps to avoid a further worsening of the crisis and to buy time for the elaboration of the plan. The boundary between the preparatory and the implementation phase of the recovery plan is rather blurred. The formalisation of a plan could, in fact, be a simple rationalisation of decisions on strategic lines already defined by the

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Corporate Financial Distress

subjects involved in the turnaround process, as in the recovery plan not all aspects of future management can be analytically described. Before analysing the formulation of the plan and recovery strategies in detail, we wish to highlight that the outcome of a turnaround process depends on the response provided by the company. In fact, once the required measures to deal with the crisis have been decided, it is necessary to act firmly in a very short time frame. According to the predominant literature, any turnaround has to take place over a period of no more than 12–18 months. Clear signs of a turnaround must be seen in the first 3–6 months, so that the company can supply the first positive results within the next 12 months. The turnaround will necessarily have to be oriented to the improvement of the overall management of the company with the objective of long-term financial rebalancing, and will therefore not be focused on a single problem. A lot of cash-based approaches, with their obvious consequences in terms of asset disposal (financial restructuring) and, in general, all turnarounds that emphasise cash flows for the service of debt, fail after a few months – i.e. they do not restore the company’s competitiveness – as the management is unable to deal with the stakeholders system (Dallocchio & Salvi, 2011). The distance of the company from its break-even point is the real source of complexity of the turnaround process. In fact, if the company is close to that point, a cost recovery strategy focused only on cost reduction may be effective. If, on the contrary, the company is far from reaching the break-even point, the recovery process needs to be much more invasive, with a lower probability of success. The commonly accepted steps described in literature concerning the successful strategies of a turnaround process are as follows: (1) downsize the company’s activities by focussing on the most successful core business and eliminating all non-strategic activities (back to basics); (2) try to obtain consensus from all the stakeholders involved in the recovery (including the company organisation). Identify a leader who can positively manage this process by taking real decisions, even when the tolerable margins for errors are very low and who can act quickly with his team; (3) temporarily entrust external experts with the task of making decisions at difficult times; (4) maintain strategic investments in order to achieve the objective of long-term economic balance; (5) set up possible spin-off activities to divest all non-strategic or unprofitable assets and inject new finance; (6) the speed of change is essential to identify new trends in the core business: the structure will therefore have to be more sensitive to all signs of change; (7) cost reduction has to be carried out systematically to create a virtuous process and improve production efficiency; (8) increase the flexibility of the organisation and create the conditions for other activity in case future changes become necessary;

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(9) achieve alliances or long-term agreements with both customers and suppliers to increase organisational and production flexibility. A successful turnaround results in a significant increase in the company’s reputation and image in the outside world, thus allowing for the complete restructuring of the company and its repositioning on the market. It should be emphasised, however, that short and very short-term objectives are a distinguishing feature of the recovery process. In this case, reference is made to the need to identify and rapidly resolve the expressive symptoms of the crisis, trying to achieve positive cash flow shortly after the start of the recovery process to represent a clear reversal of the usual trends in income results. Short and very short-term objectives can be achieved essentially through better efficiency in the management of resources. Therefore, we try to influence the results through actions that are bound to improve the efficiency of existing processes, so as to contain costs and support revenues. Among the main actions to adopt, there is the use of the redundancy fund, the elimination of some processes or the modification of the product range, the search for higher performing technologies, a more prudent purchasing policy, actions to improve the collection cycle, so as to free up precious financial resources and, at the same time, positively affect profitability. These steps are sometimes accompanied by other complementary actions that are aimed at raising liquidity but which normally take longer to set up; for example, the sale of real estate, land and buildings, as well as industrial plants with a view to reducing activities. The recovery strategies are described in the recovery plan (RBP), which consists of two complementary documents: the business plan and the financial plan. The first is usually prepared by the management of the company, with the possible support of external consultants. It is a formal document through which the strategic actions, which are the milestones for the return to profitability, are explained. The second is usually prepared by external consultants and is focused on the company capacity to generate income. It deals with the financial structure of the company and with the financing sources and their time frame. On the basis of the business plan, the advisor selected for the purpose will negotiate – with the company’s creditors, and in particular with the banking system – a redefinition of the existing contractual terms and conditions and the new financial requirements necessary to achieve a recovery of the financial situation. The RBP normally suggests two types of intervention: an external intervention and an internal one. The external one concerns the recapitalisation of the company through equity contributions; the conversion of credits into risk capital, through the subscription of a reserved capital increase; the total or partial new issue of debt, through definition and cancellation agreements; the renegotiation of the conditions of existing loans, in particular the applied interest rates; the provision of new finance; the repositioning of short-term debt into medium/long-term debt through debt consolidation. The internal intervention, on the other hand, is focused on the sale of nonstrategic capital goods, entrepreneurial choices aimed at increasing the efficiency

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Corporate Financial Distress

of the production structure (cost reduction, increase in profitability margins); and on the self-financing of the company through current operation flows. The common goal of these operations is the generation of an additional flow of liquidity – in addition to the one produced by the core business, in order to contribute to reducing the overall debt: this will make the plan credible for the repayment of the debt exposure to creditors. The debt reduction leads, as a natural consequence, to a reduction in interest expense and this has a positive knock-on effect on the accounts and on the chances of success in the recovery process. Together with the restructuring of the balance sheet, the company also has to focus on the recovery of the aforementioned management efficiency, i.e. the socalled economic restructuring. The latter may concern the rationalisation of the company structure and its strategic reorientation. The first type of intervention is aimed at achieving an economic balance through a better use of the productive, commercial and financial resources of the company. Cost reduction consists in the rationalisation of business processes and in the identification and elimination of all inefficiencies. In addition, techniques to improve the quality of revenues must be implemented. In the continuous pursuit of this rationalisation, a strong effort has to be made to reduce the production volumes of the product categories characterised by low yield, with a consequent reduction in personnel. Further on, working capital improvement policies must be implemented; for example, by the adoption of an effective control dashboard leading to a reduction in inventories, the rebalancing of receivables and payables linked to the production and the commercial management of the company. The company’s overall strategy should also be an area under deep investigation and analysis. The management is compelled to shift its attention from the need to generate profits in the short term to a medium/long-term development perspective. From the financial point of view, attention must be paid first and foremost to the fact that the current crisis in the financial markets has led to a shortage of financial resources, making corporate financial interventions even more delicate and difficult. A company financial restructuring plan must achieve the perfect synchronicity between the need for financial resources and the debt repayment flows. Financial resources are necessary to carry out the business plan and reach economic balance in the short term and finally financial balance in the long term. The balance sheet is determined, as generally acknowledged, by the ratio between equity and debt; in order to reduce the incidence of debt, the company will have to agree to a debt restructuring with credit institutions that is consistent with the cash flows that the operational activity will be able to achieve in general, as forecast in the business plan. So, the financial plan will channel the successful achievements coming from the industrial plan and use them for the reorganisation of the financial structure, this will grant the company’s survival and make the relaunch of its business solid and credible, even in the long term.

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One of the first actions suggested in the financial plan concerns equity. A capital increase is usually required, and it may be obtained from the existing shareholders or from new investors. This measure works on two levels: it builds confidence in the company among stakeholders and it reduces the net financial exposure. In terms of confidence, any capital increase highlights the willingness of shareholders to seriously pursue the proposals of the business plan, demonstrating they are the first to believe in the recovery and restructuring plan. In addition to the capital increase, financial recovery plans normally require the consolidation or the renegotiation of terms in the existing debt position by extending them over a longer period. Through debt consolidation, banks undertake not to request any repayment before a fixed deadline and allow a reduction in the loan rates. All this, of course, depends both on the financial needs expressed by the new financial structure and on the perspectives emerging from the industrial plan. As a rule, financial restructuring plans require that certain economic and financial ratios, representing the level of indebtedness of the company’s overall performance, be respected throughout the duration of the recovery plan. This condition will allow for the monitoring of any progress of the recovery plan and will also protect the lenders. The most commonly used indices in practice are the ratio between the net financial position and the EBITDA, the net financial position and the shareholders’ equity, the financial charges and the turnover. These indices can be used as covenants, either as a possible element of default, beyond which creditors mature the right to immediately request repayment for the lent sums, or as a parameter to monitor the performance of the plan. The company performances have to be periodically communicated to the lenders and deadlines are defined by the debt consolidation negotiations. A further important element of the recovery plan is its valuation to determine the enterprise value of the company subject to the plan. The objectives of this assessment refer to the need to measure the economic effects that the recovery plan may determine, together with the definition of an initial economic reference value for the company itself and the parties involved in the recovery. In fact, it can be said that the company, in order to return to value creation, must break the vicious circle of the crisis by eliminating the anomalous conditions at its origins. Consequently, the recovery plan must be correctly applied to the company being restructured; all the signs of a return to value, the past mistakes and the adopted solutions, have to become part of the company’s new intangible assets, in order to outline a new configuration. The deeper the awareness of the mistakes that led to the crisis, the more successful this process will be.

4. Developing a Business Turnaround Plan The industrial turnaround plan is a tool to simulate business dynamics, projected in the medium-long term, and consisting of a series of documents in which the entrepreneurial idea (or, in any case, the basic idea of any economic initiative) is

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Corporate Financial Distress

represented in qualitative and quantitative terms. In the Business Plan, the author elaborates and summarises all the ideas, the consequent programmes and the initiatives which characterise the entrepreneurial project. The Business Plan is essential not only to define the lines of intervention, which may be modified in the implementation phase, but also to quantify three utmost important elements for the evaluation: the additional resources to invest, the timing and the expected objectives. The business planning process, when correctly carried out, involves all the company decision-making actors. The active involvement of people, at various levels, in defining the operational plans, constitutes a prerequisite to create the social consensus which underlies the company’s success. Even if one resolves to engage a consultant for technical support, it is important that they work in contact with those who have to take the strategic (and operational) decisions, helping them to understand the consequences of the different alternatives, simulating the economic and financial results originating from the various hypotheses and, therefore, helping them to finalise the entrepreneurial project. The basic sequence of the business plan may be represented as follows:

• • • • •

basic objectives; scenario hypothesis; competitive strategy; operational behaviour; prospective financial statements.

The economic and financial data therefore represent the concluding phase of the plan which has to respect a logical structure. The professionals involved in the realisation of the Business Plan, as well as the number of documents and data taken as reference, will certainly vary depending on the market sector and the size of the company. Nonetheless, the approach to the problem has to be the same for all economic initiatives: the fundamental objective is to rationalise and plan all the business choices and summarise them in a complete, representative and easy-to-read document. The industrial plan, according to the Italian Stock Exchange (BorsaItaliana), should respond to some key features such as financial sustainability, consistency and reliability. The guidelines issued by the CNDCEC in 2011 highlight, in addition to what is suggested by Borsa Italiana, how the plan should be drawn up respecting the required principles of clarity, completeness, reliability, neutrality, transparency and prudence. According to the above-mentioned guidelines of the CNDCEC, the Business Plan should consist of at least the following essential documents:

• •

the description of the business project: contents and modalities of the temporal implementation schedule; the description of the product/service;

Corporate Recovery Plans

• • • • • • • • • • • • • • • • •

45

company history; analysis of the history of the shareholders, directors and top management; analysis of the organisational structure; analysis of the administrative aspects; analysis of human resources; analysis of logistics; market analysis and marketing choices; sales plan of the product/service; investment plan and related resources; analysis of know-how and user intellectual property; description of the production cycle, including the disposal and/or reuse of waste and leftovers; description of the environmental and safety aspects, if significant; analysis of the financial structure; balance sheet, economic and financial forecasts; strengths and weaknesses of the project; final considerations; attachments.

The recovery plan must be prepared according to the principles and criteria which are typical of a business plan, resulting therefore in a document composed of several distinct parts, but closely interconnected, divided between a descriptive and a quantitative section. The descriptive section must report a detailed and organic representation of what are the assumptions, the reference framework, the context in which the company operates as well as the products, production processes and structure, the initiatives undertaken and those to be implemented, in the basic hypotheses of the various projections, strategies and procedural developments of the planning. In this section, while representing the initial situation, a section will be dedicated to not only to explaining the effects of the crisis but also, and above all, to the causes which determined the company imbalance. This explanation is essential as the plan must show the recovery strategy as a series of actions aimed at removing/ overcoming the specific causes which led to the crisis. Therefore, if the origins of the crisis have been identified as a low market demand, a strategy aimed essentially at reducing costs would only work for a short time and could not lead, in the long term, to a recovery of the physiological economic conditions (Quagli, 2011). The quantitative section is made up of several complementary documents, such as: the industrial plan (where the various hypotheses of strategic repositioning of the company and the related conditions of feasibility are defined); the financial plan and the restructuring of liabilities (having as an objective the financial restructuring of the company and its structure in the medium to long term); and the economic and financial projections (a statement that quantifies the possible economic and financial consequences of the formulated recovery programme). The plan has to report the possible evolution in the short and medium term, objectively predicted, of the company situation, until it reaches a new equilibrium

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point with a view to future relaunch. It must be inspired by the principle of transparency, among others, which is strongly connected to those of clarity and reliability. This principle is achieved when it is possible to identify the source for each specific action, and above all when every element of the plan can be reconstructed backwards, also through the examination of work papers, documentation and access to all information used by the plan author (Quagli, 2011; Pollio, 2009). The structure of the business plan should have the features reported in Fig. 2.1. The turnaround plan must primarily take into account the following factors:

• • • • •

investments; financing; forecast management trend; forecast trend of operational and financial management flows; financial needs forecast.

With reference to the investments, it will be necessary to carry out a detailed analysis of the company assets, specifying their current value and identifying any asset deemed unnecessary for the business continuity which is possible to dismiss. Normally, one of the first rules of any recovery plan, consists in the dismissal of all the activities which do not belong to the core business. For this purpose, it will be necessary to prepare a document that represents, in a fully detailed form, the situation of future interventions on corporate assets in the medium-long term perspective. The second step necessary for the preparation of the industrial recovery plan involves the analysis of the forecast financing sources and of the payment methods to creditors; it will therefore be necessary to analytically state all the payment methods to be adopted (Allegrini, 2010). In the event of a financial crisis, the optimal solution could be the rescheduling of corporate debt.

a. Executive Summary b. Sector description c. Market description d. Description of products and brands e. Production process description f. Description management team g. Description of the strategy h. Marketing plan i. Operational plan l. Simulation balance sheets and cash budget

Fig. 2.1.

Descriptive section

Quantitative section

Business Plan Structure. Source: Adapted from Ambrosini, Andreani, & Tron (2013, p. 68).

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Debt rescheduling, resulting from a renegotiation agreement, consists both in reshaping the debt repayment times towards banks and in delaying payments to suppliers. In other words, the agreement could postpone the due date of the debts. Although the proposal of debt rescheduling might be accepted by banking institutes, considering their economic, capital and financial strength, it could be more difficult to reach an agreement with the ‘other creditors’ (such as, for example, the suppliers) as they may not be able to stand any further delay. Financial restructuring can be summarised in the following factors:

•

•

•

the release of new finance: this is one of the hardest problems in all turnaround processes. ‘Bridge finance’ is necessary to carry on the company activity and it may be obtained through the reactivation of the self-liquidating credit lines, generally the very first to be progressively reduced by banks. So, new finance is an element which stands at the basis of lots of recovery plans, but it is not easy to secure. In order to grant ‘bridge finance’, extremely relevant in the initial phase of restructuring (when the analyses leading to the formulation of the recovery plan are still a work in progress), some guarantees may be requested: such as the collection of all operational cash flows or the income from the dismissal of assets that are no longer strategic at the same bank that is releasing the new finance; the new financial structure: recovery plans normally consider the consolidation of the initial debt position and/or the request for new medium-long term financing lines. With the consolidation, we substitute an unsecured credit (selfliquidating, etc.) with a preferential one, possibly supported by collateral bonds, etc; ratios and covenants: in order to monitor the performance of the main variables and provide an alert mechanism with contractual strength to protect banks, recovery plans normally have to respect some economic and financial indices, representative of the level of indebtedness and the overall performance of the company for the whole duration of the plan. Typically, management covenants are added to financial covenants, such as, for example, the limitation of investments to those identified in the recovery or turnaround plan or the limitation to the overall debt (Castellano & Pajardi, 2010).

If, on the other hand, the business crisis is likely to affect the company’s assets significantly, other more incisive solutions will have to be identified, such as, for example, the creditors’ possible renunciation of their rights, with the hope that business continuity will generate the necessary revenues to satisfy both the new costs and the past debts. The forecast income statement will be in the form of a progressive income statement in which the measures of the company’s economic quantities of revenues, value added, gross operating margin, operating income and net result must be clearly stated. Moreover, on the basis of the type of business plan prepared, the forecast income statement will report the forecast decreases in the costs of the

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productive factors to be achieved in the recovery period. The methods adopted to reduce the expenses and the effective policy of containing production costs have to be illustrated in detail and accurately described. It should be borne in mind that, in the hypothesis of a restructuring of the company’s activities, and the consequent planned downsizing, the economic account will have to consider the extraordinary positive or negative components resulting from the above-mentioned actions. In this sense, in order to arrive at a reliable economic forecast, it may be convenient to perform a breakdown of the economic plan by analysing the individual strategic business in detail and identifying any productive loss-making sectors. The industrial plan will also illustrate the flows of the operational and financial management, in order to demonstrate the company’s real ability to pursue profitability and take into account the effective restructuring of the company’s liabilities. In this regard, the analysis of the above-mentioned flows should be included in a financial plan, representing the lines of a multi-annual planning, the trend of the financial flows for the period and the progressive shaping of the company’s financial situation. The balance sheet and the profit and loss account, also as prospective forecasts, make up a substantial part of the plan, although they are not sufficient to analyse the company’s financial dynamics. The former, as known, may provide only ‘stock’ values referring to a given instant, while the income statement is able to express flow values, referring to the economic and non-financial dynamics. The difference between the ‘stock’ values of two successive years of the resource taken as a reference coincides with the overall financial flow shown in the statement. The cash flow statement is therefore a tool to verify the financial equilibrium in particular the treasury, and to analytically monitor the performance of management and the individual sub-units. This tool is therefore a necessary support for any corporate recovery or turnaround operation (Allegrini, 2010). The financial statement is to be structured in two documents: the first should indicate the financial situation of each period; the second one, the liquidity situation. Table 2.2 shows a short and full analysis of the financial situation, which may be conditioned by any financial debt renegotiation agreements. This document may form part of the industrial recovery plan. The improvement in the overall financial situation will be influenced by the company’s ability to achieve any renegotiated debt agreements with the banks. Therefore, the feasibility of the plan will mostly depend on the realistic options that the company has, the choices it makes, the securing of financial resources, the successful outcome of any negotiations with creditors and the methods and timing of the plan’s implementation (Brunetti, Coda, & Favotto, 1990). The second document, which has to accompany the financial plan, consists of the liquidity statement in which all changes in the flows coming from the company operations are reported and analysed as detailed in Table 2.3.

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Table 2.2. Analysis of the Financial Situation. Analysis of the Financial Situation

Year X

Year X11

Year X12

Year X13

1/2 liquidity 1 liquid securities 1 short-term financial credits 2 short-term financial debits Short-term Financial Situation 1 medium–long-term financial credits 2 medium–long-term financial debits Medium–long-term Financial Situation

Table 2.3. Statement of Liquidity. Liquidity Statement

Initial liquidity 1 revenues 1/2 increase/decrease in operating credits 2 costs 1/2 increase/decrease in operating debits 5 internal flow of liquidity 1 fixed capital divestments 1 working capital divestments 1 transfer of own equity 1 financing activation 5 total flow of liquidity 2 fixed capital investments 2 working capital investments 2 remuneration/reimbursement of equity 2 remuneration/reimbursement of financing 5 net liquidity flow Final liquidity balance

Year X

Year X11

Year X12

Year X13

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Corporate Financial Distress

This statement aims to forecast, in the multi-year planning, the net liquidity flow which will be generated as a result of the management operations to be carried out. The projection of liquidity is therefore complementary to the financial one, since it represents one of the components of the latter. The financial plan makes it possible to identify some relevant parameters and analyse the operating lines of the company. Finally, it will be necessary to indicate the company’s financial needs and the sources for its coverage. In this perspective, the detailed analysis of the annual requirement statement makes it possible to identify some parameters which act as objectives. They have to be consistent with the strategic formulation of the multi-year development plan and may be deduced from the ratio between net working capital and net invested capital and by the ratio of fixed capital and invested capital, both at the aggregate level and by business sector. Regarding the financial sources necessary to cover the company needs, they can be generated by equity or by financial liabilities. In particular, in an industrial recovery plan, the above-mentioned statement of liquidity will be of considerable importance.

Chapter 3

Financial and Operational Business Turnarounds: Execution and Monitoring Complexity (*) 1. The Recovery Project, Its Complexity and Execution A successful financial restructuring plan requires careful planning of the interventions deemed necessary to resolve the crisis and identification of the related timing. The time component in particular represents a constraint the scope of which is frequently underestimated by shareholders, directors and management as the company faces a crisis situation (Ambrosini & Tron, 2016). Time therefore assumes the features of a strategic constraint against which the sustainability of possible recovery strategies has to be assessed, also considering the amount of available financial resources, and the attitude of management and organisation towards managing the crisis context. The macro phases of the recovery project may be defined as follows:

• • •

phase (1): strategy elaboration; phase (2): negotiation of the restructuring proposal with creditors; phase (3): implementation of the recovery plan.

The preparatory activities for the definition of the guidelines fall within the scope of the first phase of the recovery plan; here more than anywhere else, the time element is a key factor. While an agreement with creditors on the recovery plan may not yet be established at this stage, it is probable that a moratorium agreement has already been signed (the so-called standstill). The duration of this is generally limited to the time strictly necessary to propose a financial intervention to creditors. As

*

This chapter is based on the earlier study Tron, A.,Valenza, G. and Caputo, A. (2018), Corporate crisis management in Italy: execution, monitoring and performance analysis of recovery business and financial plans, International Journal of Foresight and Innovation Policy, vol. 13, n. 1/2.

Corporate Financial Distress, 51–66 Copyright © 2021 by Emerald Publishing Limited All rights of reproduction in any form reserved doi:10.1108/978-1-83982-980-220211004

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Corporate Financial Distress

authoritative literature points out, in this context, the analysis activities must be guided by the speed of execution, giving priority to simplicity over perfection (in these cases, ‘fast is better than perfect’) (Danovi & Quagli, 2010). Once the guidelines for the Recovery Business Plan (RBP) have been defined, the next step will involve the negotiation of its terms with all the necessary interlocutors such as banks, suppliers, trade unions, central and local administrations, social security institutions, etc. The recovery project therefore constitutes the summary document in which the company identifies and formalises the methods to restore economic and financial equilibrium, the only guarantee to ensure the existence of the going concern assumption. As has been correctly highlighted by authoritative scholars, ‘the recovery project does not have a complete discipline either from the economiccorporate point of view or from the legal one’. In the early stages of the recovery process, communication of the reconstruction project is an important success factor (Gonza´ lez-Herrero & Smith, 2008, 2010; McDonald, Sparks, & Glendon, 2010; Sweetser & Metzgar, 2007; Williams & Olaniran, 1998). At this point, communication will be mainly internal, such as a shared tableau de bord, or dashboard. The tableau de bord is a set of ad hoc measures linked together through a series of cause–effect relationships. Each measure expresses a certain stage of the process, so that the indicators can provide an overall picture of the general systemic functioning. It is created to provide supporting information at different organisational levels and achieve the company objectives. The tableau de bord is a tool used in the context of advanced management control systems, which starts from the recognition of financial results, up to a more in-depth analysis of the physical, technical and operational causes of the deviations related to the results of each business process. It should not only concern economic–financial indicators but must also include analysis of the efficiency of the company management, the operating processes and the level of customer satisfaction, comparing financial data with indices about the quality provided and perceived by the customer (Bourguignon, Malleret, & Nørreklit, 2004; Epstein & Manzoni, 1997, 1998; Wegmann, 2000). The two main objectives of the dashboard are as follows: (1) the monitoring of the performance of the key variables (the so-called Key Performance Indicators or KPIs) and of the key processes; (2) a brief and complete reading of the deviations of the company results for the definition of corrective actions. The literature has provided some contributions on the theme of the RBP, with reference to the physiological phase of its development, but has not deepened and formalised the necessary adjustments that the business plan has to apply in the event of a business crisis which requires some reorganisation processes. Current legislation does not specifically (and not even generally) regulate the content of the company recovery project.

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53

The development of the recovery project, in its business plan component, represents the numerical synthesis of the preparatory activities and the pivot of the whole restructuring plan. In addition to confirming the possibility of achieving satisfactory margin levels and, consequently, the validity of the proposal to be presented to creditors, the plan aims to define the financial needs necessary to support the turnaround process. These requirements are to be compared with the amount of resources available for the plan and determine the terms to ask for a moratorium and, possibly, for new financing from the banking system. The construction of an appropriate RBP allows the company to choose the most suitable legal instrument to achieve its recovery goals; the specificities of the rehabilitation project – according to the legal instrument which has been selected – are rather irrelevant, while the legal effects, due to the application of different tools, are obviously different. From an economic–business point of view, the recovery process may vary depending on the legal instrument chosen to solve the crisis. Such a choice is attributable, first of all, to the type of crisis that has to be faced (crisis with internal or external manifestation). The specificity of the recovery projects, according to the different relevant legal institutions which will be presented fully in the next chapter, is summarised in Fig. 3.1. In the early stages of the process, communication will be mainly internal and will aim to explain the business situation from different relevant profiles (product life cycle, strategic positioning, company cost analysis, final income statement and forecasts, financial balance sheet, situations of tension with stakeholders and/or with particular categories). Then it will be necessary to deal with the outside to negotiate the necessary permissions and communicate the recovery plan as a whole. The external communication phase is generally very delicate since any failure at this stage may put business continuity at stake and involuntarily run into liquidation situations (Giacosa & Mazzoleni, 2011, 2012). Finally, it should be noted that the recovery process – in its various stages of development – will lead to identifying timing and accountability. A further relevant element for the success of a recovery plan is the identification of the principles of governance and the figure in charge of managing the turnaround process. Solutions in this sense may be manifold; some scholars have highlighted how Italian companies often turn to expert managers, specialised in turnaround processes, or it is the business owner themselves who directly leads the recovery process. It must be pointed out that a delicate aspect of recovery financial plans is represented by their feasibility. Recovery plans are achievable when they meet the following conditions:

• •

they must be compatible with the characteristics and trends of the external environment (e.g. any growth in revenues must be consistent with the expected growth rates of the sector and with the competitive positioning of the company); they must be internally coherent, both from the point of view of the correlations among variables and the availability of resources (e.g. productivity improvements that are realistic and consistent with the technical returns of fixed assets and with the work rhythms of the staff);

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Corporate Financial Distress

KPI's

TURNAROUND ROAD-MAP: AN EVERYDAY WAY OF LEADING

Financial Statetement Financial and Functional Balance Sheet Reclass. Analisis: ratios, margins, flows Z-Score, EM-Score

T-3

T-2

T-1

T0

Profit & Loss Balance Sheet Financial Statement (focus on: Net Operative Working Capital) Financial and Functional Balance Sheet Reclassification Analysis: ratios, margins, flows (based on Basilea 3) from: Z-Score (Probability-of-Default), EM-Score (Credit Rating) to: Probability-of-Excellence biz set-up Sensitivity & Stress Analysis: Contingency Plan

Firm/Business Evaluation Module

Balance Sheet

ta a Analysis of the consistency of comparable data

Profit & Loss

Analysis of the causes of the crisis (exogenous, s, endogeneous, extraordinary events, t etc.) t )

INPUT

IAS-36 Impairment Test Module

OUTPUT: A BUILT-TO-LAST DESIGN PLAN HYPOTHESES (ISAE-3400): INPUT MATRIX MIRRORING BIZ MODEL

Plan Deployment, Net Cash Available and KPI Monitoring

T+1

T+2

T+3

T+4

T+5 -->

TODAY Mapping Biz Dynamics & Input Tab (to be linked to Sensitivity & Stress tests): Revenues & Costs generation (industrial algorithms), Net Operating Working Capital element (DSO, DPO, DIO, CASH), Capital Structure (Net Capital, Debt), Extra-Ordinary cash-related elements.

ACTUALS

CURRENT

PLAN

Emergency Mode: (1) Stop Bleeding, (2) Stabilize, (3) Incubation, 4) Develop, 5) Sustain

Financial Covenants

DELTA-PERFORMANCE

Operative Covenants

DELTA-ORGANIZATION

Organization Design

Fig. 3.1.

Organization Assessment

The Turnaround Road Map. Source: Adapted from Tron and De Giovanni (2016).

T

Financial and Operational Business Turnarounds

• •

55

they must have a medium-normal degree of difficulty in their implementation, such that their realisation can be considered probable and, in any case, that their valuation is the best estimate of future events; they must be supported by concrete elements that demonstrate, even in the short term, an evolution consistent with the recovery plan (e.g. a binding commitment by a third-party lender if the recovery plan is based on the acquisition of new financial resources), and, in any case, the plan must lead to the resolution of the crisis over a maximum time horizon of 3–4 years.

2. Company Organisation: A Strategic Resource in the Recovery Process Tron, Valenza and Caputo (2018) presented a study in which they carried out the research into execution, monitoring and performance discussed in the following paragraphs. Organisational change is an important aspect related to the recovery planning and turnaround process (Kanter, Stein, & Jick, 1992; Armenakis & Fredenberger, 1997; Barker & Duhaime, 1997; Pearson & Clair, 1998; Carroll & Hatakenaka, 2001; Wang, 2008). After drawing up the recovery plan, the manager must establish which organisational structure is able to support and facilitate its implementation. The planned organisational structure must be able to ensure that the recovery plan is implemented in the most efficient and effective way, while at the same time recovering sustainable long-term competitive advantages that will allow the crisis to be overcome. Since the organisational change may involve the insertion of new resources (human, material, financial, etc.), this should be highlighted in the recovery plan (Principi, paragraph 6.3.3). In particular, it is necessary to emphasise the compatibility between the company resources that are expected to be introduced and the interventions that the reorganisation plan requires (Principi, paragraph 6.3.4). As the recovery plan implies the pursuit of a specific strategy, it is necessary to prepare an organisational structure to support the implementation of the strategy. The literature has largely focussed on the strong links between strategies and structures (Cafferata, 2009; Chandler, 1962; Paletta, Alimehmeti, & Tron, 2016; Sloan, 1964). When designing a new organisational structure consistent with the strategies defined in the recovery plan, some questions must be asked. These questions are useful to assess the operational feasibility of the recovery plan (Ambrosini, Andreani, & Tron, 2013):

• • • •

who will implement the recovery plan? with which professional skills and abilities will this subject/team implement the recovery plan? what activities should be carried out to implement the recovery plan? which activities are crucial for the success of the recovery?

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Corporate Financial Distress

The recovery plan, at least in the managers’ intentions, is always ‘feasible’ and suitable to restore the conditions of economic and financial equilibrium. However, many plans disregard some or all expectations, even if the construction of the economic–financial performance indicators is based on reasonable assumptions. One of the main causes of the negative performance of recovery plans is a lack of detail (Reina, 2003). Often, strategic, financial and organisational information is not provided at a sufficient level. It is not possible, in fact, to support the implementation of the actions foreseen in the recovery plan if it does not identify the operating procedures that will help achieve the sequence of planned activities through a renewed organisational structure (Ambrosini & Tron, 2016). The organisational element is therefore usually underestimated. Even if some industrial plans are complete, with regard to the planning of the new organisational structure, the phases of the organisational restructuring are often not synchronised with respect to the operational activities envisaged in the action plan. It should, however, be stressed that redesigning the organisational structure, especially in a recovery area, is a very complex activity that requires specific skills and a particular attention both at the level of the ‘macro’ organisational structure (roles, responsibilities, skills, processes, procedures, etc.) and on a ‘micro’ cultural level (attitudes, behaviours, etc.). The organisational redesign must focus on the main success factors that are, in turn, the basis of any change management activities (Diefenbach, 2007; Graetz, Rimmer, Lawrence, & Smith, 2006; Todnem, 2005). If the organisational changes call for significant interventions on the staff and the number of employees, it is necessary to include information on the main business sectors and organisational units involved in the recovery plan. When the recovery plan involves reducing the workforce, the cost/benefit estimate must be expressed. If, on the other hand, the recovery plan highlights the need to maintain staff and manage redundancies, it is necessary to discuss the extraordinary costs and the relative timing (Principi, paragraph 6.3.4). Interventions affecting the organisational structure must therefore be consistent with the industrial and financial strategy to ensure maximum support for the specific business actions envisaged in the recovery plan. The sequence of the various organisational interventions must also be synchronised to the business actions, according to the rules of prerequisites. The objective of the planned organisational structure will be to guarantee the sustainability over time of the performance forecast by the recovery plan, both in the short and in the long term.

3. Organisational Recovery as an Element of the Action Plan The process of organisational recovery must follow three phases (Ambrosini & Tron, 2016): (1) the ‘assessment’ phase; (2) the ‘design’ phase; (3) the ‘implementation’ phase.

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The three phases must be managed by a multifunctional team, in order to adequately take into account all the sectors of the company involved in the redesign of the organisational structure. The team must be able to consider the results-objectives to be achieved at the business level, and accordingly redesign the organisational structure as their basis. In other words, organisational changes must be planned and have to be consistent with the changes envisaged for the business model of the company. The process of organisational redesign must be managed by a Chief Restructuring Officer (CRO), i.e. a manager/professional who is responsible for the process of operational and financial restructuring of the company in crisis (Waisman & Lucas, 2008). The CRO embodies functions which range from liquidity management, to the implementation of the restructuring plan, to the selection and training of managerial figures that can strengthen the team. The team managed by the CRO must be set up and communicated in a formal manner to the entire company. The CRO takes on responsibility for the management and implementation of the company’s operational, financial and organisational recovery process. The delegation of powers to the CRO throughout the recovery phase must be clear and well known within the company, and his hierarchical position must be of a high standing. In particularly delicate and complex cases, this figure coincides with the role of General Manager or Chief Executive Officer of the company in crisis. The CRO represents the change agent, i.e. the catalyst element of the set of processes subjected to complex and dynamic changes (Armenakis & Bedeian, 1999; Ford & Ford, 1995; Westover, 2010). The key element of a performing organisational model is seemingly conceptual but in reality they have strong characteristics of concreteness and measurability. Concreteness and measurability are required since it is necessary to verify any possible deviations between planned objectives and the results that are actually achieved as we proceed with the recovery. The analysis of the deviations is necessary to prepare adequate corrective actions during the implementation of the recovery project (Ambrosini & Tron, 2016). There are some ‘macro’ elements on the basis of which the organisational structure of the company must be redesigned. These elements are as follows:

• • • • • • • • • •

management based on principles; leadership; involvement and authority; open communication; focus on business results; focus on the customer/consumer; regulation of organisational changes; learning-oriented environment; development of opportunities; transversal learning.

The organisational infrastructure must also be designed on the basis of ‘micro’ elements in order to accurately and punctually calibrate the business interventions

58

Corporate Financial Distress

envisaged in the reorganisation plan. It is necessary, therefore, to compare the current business situation with the organisational structure that generated it (analysis phase), and then identify all the strategic organisational steps to achieve the expected business situation (design phase). The analysis phase (assessment) is perhaps the most critical because the causes of the crisis must be sought by evaluating systematically the different profiles of company management and identifying how much the crisis derives from an inadequate organisational structure. It will be necessary to conduct this diagnosis correctly as the assessment has to be as effective as possible and, above all, it has to be oriented towards the actionability of the recovery and business plan (Slatter & Lovett, 1999), as shown in the following Fig. 3.2. Once the assessment phase has been carried out, it will be necessary to proceed with the actual interventions aimed at the organisational change, which will have to follow these steps (Ambrosini & Tron, 2016):

• • • •

tracing the causes that lead to current results; identifying the problems/opportunities of the organisational design; identifying the operational strategy to carry out organisational change; evaluating the operational strategy of organisational change.

Organisational change must be accompanied by a real cultural change (Alvesson & Sveningsson, 2016; Bate, 1994; Rashid, Sambasivan, & Rahman, 2004; Schneider, Brief, & Guzzo, 1996). In fact, cultural change can facilitate the implementation of the interventions envisaged in the recovery plan. In other words, cultural change must be functional to the realisation of all the activities forecast in the recovery process, which are fundamental for the expected performance (Tocquigny & Butcher, 2012). It is therefore necessary to provide:

• •

•

sensitivity and stress analysis: this provides simulations on the feasibility of the recovery plan based on the possible variability of the basic assumptions and, consequently, of the company performance; the deployment plan and the action plan focused on ‘organisational leadership’, which must be based on the careful matching between the ‘manager’ and the ‘plan actions’, where the commitment allows a more controlled transition in the switch from strategy to concrete actions (Morgan, Levitt, & Malek, 2008); the monitoring plan, which provides for the preparation of the ‘KPI scorecard’, which allows the monitoring activities to be planned after the preparation of the recovery plan. The KPI scorecard makes it possible to schedule the ‘business reviews’, during which the deviations are analysed and appropriate plans are formulated for the recovery of any lost efficiency (contingency).

During each project phase, from the formulation to the implementation of the recovery plan, there must always be a reference to the relative operational KPI for each economic–financial KPI (with related organisational impacts).

ACTUALS KPI

2016

2017

2018

2020 Target KPI 2019

Base Plan

Default (*)

Delta Performance Actual

vs. Base

vs. Default

Sales

0

Less Cost of Sales

0

0 0

Gross Profit (EBITDA)

0

0

0

0

NET PROFIT (EBT)

0

0

Fixed Assets Net Assets

0 0

0 0

Net Equity

0

0

Current Assets Current Liabilities Financial Charges FREE CASH FLOW FROM OPERATIONS

0 0 0 0

0 0 0 0

0 0,00 0,00

NET FINANCIAL POSITION (NFP) NFP/EBITDA NFP/ NET EQUITY ROI ROE ROS Gearing Ratio Sovency Ratio

DEFAULT RISK INDEX: Z:SCORE (*) 0.717a + 0.847b + 3.107c + 0,42s + 0,998e a = Working Capital/ Total Assets: b = Retained Earnings / Total Assets: c = EBIT / Total Assets d = Market Value of Equity (*)/ Total Liabilities: e = Net Sales / Total Assets: VERY HIGH IF: Z - SCORE < 1,23 MEDIUM-HIGH RISK IF: 1,23 < Z-SCORE < 2,7 (*) PMI Z-Score: Market value of Equity = Net Equity

ACTUALS 2017 2018 0,000 0,000

2019 0,000

2020 Target KPI Piano Base Default 0,000 0,000

0,0% 0,0% 0,0% 0,0% 0,0% Delta Performance vs. Base vs. Default 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00

MEDIUM RISK IF: 2,7 < Z - score < 2,90 VERY LOW IF: Z - SCORE > 2,90

KPI Scorecard Monitoring. Source: Adapted form Tron and De Giovanni (2016).

59

Fig. 3.2.

2016 0,000

0 0,00 0,00

Financial and Operational Business Turnarounds

Less Expenses

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Corporate Financial Distress

This identification will also facilitate the deployment and monitoring phases, allowing a simpler and direct allocation of resources in the restructured company organisation. KPIs can be both economic–financial and asset-type as well as qualitative and quantitative indicators of a different nature (Franceschini, Galetto, & Maisano, 2007; Kaplan & Norton, 2001; Parmenter, 2015). The whole process is characterised by a precise correlation of underlying fundamental operating variables and derived performance variables. The correct execution of these phases determines the probability of success of the recovery plan, and the subsequent achievement of the expected performance related to the execution of the plan itself. The analysis of the deviations (the so-called delta-performance), that should be carried out during the execution phase, between the performance envisaged in the recovery plan and the finalised one (monitoring), is an important opportunity for evaluation and improvement (fine tuning) of the operating parameters that govern the performance. In this way, it is possible to develop the skills for the identification of the ‘basic’ causes (of the underperformance) and of the relative contingency actions (and back up) to be performed.

4. Feasibility of the Recovery Financial Plan as a Result of a Correct Execution Process (Deployment) In order to minimise the risk of a possible inadequate implementation of the reorganisation plan, the Principi provide for a specific deployment and monitoring phase to be described, together with the preparation of specific contingency plans to mitigate any unexpected unsatisfactory underperformance, which, in some cases, could undermine the success of the recovery operation (Anderson & Anderson, 2010; Paton & McCalman, 2008). The feasibility of the recovery plan is the high probability that its correct implementation will result in the expected performance. Feasibility, therefore, is strictly related to an organisational redesign that is coherent, not only with a renewed strategic architecture but also, and above all, with all the individual elements making up the specific organisational structure (Burton, Eriksen, H˚akonsson, & Snow, 2006; Burton, Obel, & DeSanctis, 2011; Child, 2005):

• • • • • •

skills; work; the organisational structure; decision-making and authority delegations; information and reporting system; performance-based remuneration system.

The organisational change required to successfully implement the reorganisation plan must therefore be well described within the recovery plan itself with

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an appropriate level of detail, representing the areas of specific assumptions of accountability of the actions defined to govern and manage the company (Lenahan, 2011; Reina, 2003). Such a detailed organisational analysis immediately allows for the identification of the possible gap between the current situation that led to the crisis and the future situation envisaged in the recovery plan. The approaches to cover this gap (technical training, management training, transfers and/or merging of functions, redefinition of responsibility and command strategies, etc.) must be included in the recovery plan and must above all be planned, on the basis of priorities and prerequisites, so that the new organisation is adequate to support the effective and efficient implementation of actions to support the recovery plan (Lewis, 2006; Lenahan, 2011; Butera, 2009; Trequattrini, 2004; Bianchi Martini, 2009; Foglio, 2011; Paletta, Alimehmeti, Tron, 2016). Equally, therefore, to the economic gap analysis (which is normally articulated through the KPIs of an economic, financial and equity nature), it is necessary to structure the organisational gap analysis. In short, the Action Plan, which expresses the ways in which the expected performance level will be achieved, is nothing but a system of representation of ‘Delta-KPI’ (Principi, paragraph 8.8). The KPIs subject to deployment and monitoring are usually the traditional parameters of an economic, financial and equity nature (revenues, EBITDA, Cash Flow From Operations, Net Assets, Net Financial Position, etc.) as shown in the following figures. Based on the results of the sensitivity and stress analysis, it is also advisable to monitor the fundamental elements of the Circulating Capital (above all the inventory rotation and the collection times of the customers – DSO: Days of Sales Outstanding). In some cases, the KPIs also have a qualitative nature and are related to events that are clearly identified in the recovery plan, for example, actions regarding organisational aspects (manager change, training, delegations of responsibility, etc.). A Delta-Performance scheme of operational value, well-structured and segmented at the highest possible level of detail, can be used as an effective tool for the allocation of resources, thus ensuring the right focus, abilities and skills required for the inherent complexity level of the recovery plan. In this regard, the sensitivity analysis of the ‘base’ recovery plan will make it possible to also predict, in addition to ‘breaking’ scenarios of the recovery plan, the ‘delta-performance’ scenarios that will have to be subjected to a deployment control (Akao, 2004; Hino, 2006) and to a careful monitoring by the company management in order to guarantee the achievement of the objectives set out in the plan. A graphical representation of the delta-performance scenarios analysis is shown in Fig. 3.3. The figure described above identifies both the line of the ‘guard level’ and that of ‘the default level’. Both must be constantly monitored and need appropriate deployment. The deployment consists of three critical moments (Ambrosini & Tron, 2016):

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Corporate Financial Distress

Fig. 3.3. Sensitivity Analysis and Determination of ‘Delta-Performance’ Scenarios. Source: Adapted form Tron, Valenza and Caputo (2018). (1) sharing with the entire company and the stakeholders the contents of the recovery plan; (2) assigning responsibilities in the action plans; (3) starting the preparation of critical KPI scorecards. The assignment of responsibilities will start at the same time as the launch of those operational changes needed to adequately support the appointed managers to take charge of the plans (training, reporting, organisational restructuring, etc.). Following you will find a table showing a deployment action plan sample (Fig 3.4). The time intervals characterising the start of a recovery plan are obviously limited and the possibility of planning all the actions with an appropriate chronological sequence is highly unlikely. Therefore, during the start-up phase, the deployment will have to serve an imperfect organisational structure which, at the same time, will be subject to continuous reengineering. This aspect will not necessarily be a serious problem for the company management if, during the drafting of the recovery plan, the Delta-Organisation has already been identified, analysed, redesigned and described with all the temporal references to build, as quickly as possible, the right business operating structure (Caputo & Tron, 2016). The production of the scorecards related to critical KPIs to be included in the recovery plan is an equally important activity that, if well designed from the beginning and appropriately described in the plan, allows for a broad measurability of the current and expected performance. In this way, it is possible to take note of the presence of a ‘control dashboard’ that will allow the company

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63

FIRM - DEPLOYMENT ACTION PLAN ACTION PLAN "Contingency" Action [***]

LEADERSHIP Leader [*]

Support [*]

LINK TO RECOVERY BUSINESS PLAN When

State

Next step

KPI impact [**]

Marketing & sales

Industrial operations

New business development

Finance & Control

"Master" Action

[*] Name, Surname, Role [**] link to the KPI Scorecard (Ricavi, EBITDA, FCFO, NWC, etc.) [***] the contingecies actions have to be monitored and linked to RBP and covenants

Fig. 3.4.

Deployment Action Plan. Source: Adapted from Tron and De Giovanni (2016).

management to have the opportunity to periodically check the correct achievement of the actions envisaged in the recovery plan (Cerica, 2010; Kaplan & Norton, 1996; Lewis, 2006). The most important elements of the scorecard are: (1) the correct definition of targets; (2) the correct definition of the measurement/reading frequency. Regarding the choice of targets, not only the values associated with the ‘base’ plan but also those related to the safety thresholds identified in the sensitivity analyses should be taken into account. In particular, the adoption of two threshold values is recommended: the first one identifies the level of ‘guard’ beyond which the business is at risk; the second one identifies the real level of ‘break/default’ to be in line with others. The area between the guard value and the break/default value, i.e. the high stress zone, must be designed in line with the organisation’s capacity and speed of reaction. In other words, the Delta-KPI, in order to be restored in the range of the correct values, will require the execution of specific actions (so-called ‘contingency’) that the organisation will realise with a certain delay compared to the Delta-KPI, and this delay must not be higher than the ‘drift’ time of the KPI towards the breaking/default threshold.

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5. The Monitoring of the Recovery Business Plan The monitoring process must already be scheduled during the formulation of the recovery plan hypotheses. The hypotheses on which the planned interventions are based must themselves be subject to monitoring during the implementation phase of the recovery plan (Caputo & Tron, 2016). Once they have been formulated during the planning phase, the hypotheses (or ‘fundamental indicators’) are always linked to managers who will then be held accountable. Certainly, in every company dashboard (KPI Scorecard), the deviations of the economic–financial– equity indicators that represent the state of health of the company must be reported. The basic steps for a reliable and effective monitoring process are the following (Ambrosini & Tron, 2016):

• •

• •

• •

defining, during the formulation of the recovery plan, its assumptions and the relational algorithms for the correlation between these assumptions and the economic–financial–equity performance in a clear and precise manner; formulating the sensitivity analysis on the recovery plan’s assumptions and noting the maximum variability that keeps the performance in the perimeter of business continuity. This variability will then be used as an indicator in the monitoring process to increase sensitivity in the management for the implementation of any corrective actions to avoid entering the default perimeter; defining the accurate association between hypotheses during the formulation of the recovery plan; and defining the organisational managers who will work during the implementation of the recovery plan to verify the variability of performance as a consequence of the variability of the hypotheses; translating both the hypotheses and the performance indicators into operational terms for an efficient and concrete possibility of a daily performance management. For example, instead of allocating a target of X M€ for stock/ warehouse to the warehouse manager as part of a net working capital reduction action, the X M€ value is translated into the number of SKUs (Statistical Keeping Units, i.e. the number of references managed in the company), into the number of rotation days or into a particular activation of consignment goods policy to be agreed with suppliers; institutionalising the accountability matrix, that is the association between the operational indicators (hypotheses) underlying the performance and managers responsible and the correlation of the recovery plan leadership to the organisational levels to which this associative matrix refers to; institutionalising the monitoring process (gap analysis), keeping the managers’ focus strictly and punctually on the effects of the deviations of the operating indicators on the deviations of the company’s performance.

The heart of the process for an effective monitoring involves the institutionalisation of a cycle of periodic business reviews that must be incorporated in the previously illustrated operational and corporate governance process. These periodic business reviews will have a defined agenda focused on the identification of

Financial and Operational Business Turnarounds Phases

Actors

Data collection and creation of functional/divisional indicators • Economic and financial providers • Qualitative data providers • Organizational and performance data providers

Responsabilities

Data owner

Fig. 3.5.

Stabilization and analysis results

• CFO • Management • Financial control function

Management planning and control

65

Report to the top management

• • • •

CFO CEO and President Board of Directors Audit Committee

CFO

Monitoring Framework. Source: Adapted from Tron, Valenza and Caputo (2018).

the deviations of the operating parameters (underlying and related to the economic–financial performance) with respect to the objective value of the recovery plan for the fiscal-year-to-date reference period (Fig. 3.5). In order to facilitate the process of assigning responsibilities for the actions of the reorganisation and ‘contingency’ plan in the event of significant deviations, the use of a table is recommended to summarise the processes of ‘Deployment’ and ‘Monitoring’ through the KPI Scorecard, which represents the performance monitoring tool available to the company leadership and an analysis of the different performance scenarios of the recovery plan. Once the basic assumptions and the sensitivity analysis simulations in the recovery plan have provided a clear and detailed expression of all the actions that the company will have to pursue in order to achieve the objectives underlying the expected economic, financial and asset performance, it is necessary to start the monitoring phase. Monitoring is a ‘never-ending process’ that every company must have institutionalised to evaluate the health status of the business with a certain frequency (Akao, 2004; Lewis, 2006; Hino, 2006; Zanoni & Campedelli, 2007; Zanoni, 2009). Principi are very clear on this point, stating that the monitoring activity will be facilitated if the recovery plan provides intermediate reference targets in relation to which the implementation of the recovery plan must be verified (milestones) (paragraph 9.1.6). Monitoring is one of the most important processes of operational governance during the implementation of a recovery plan because the measurement of the current performance status compared to the one expected is a mandatory condition to assess the execution of countermeasures in case of negative deviations. Therefore, it is necessary to predispose a calendar (business review plan) in which the KPIs in question can be measured with a frequency aligned not only

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with the natural timing of occurrence (e.g. number of orders, invoicing, delayed collection, payments, etc.) but also with the timing of organisational reaction to prepare a contingency plan. It is important to underline that in case of any significant deviations, it will be necessary to proceed with the drafting of a new recovery plan. Changes to the recovery plan can be considered substantial when:

• •

there is a discrepancy with respect to the contents and the provisions of the recovery plan to the point of affecting its feasibility and not allowing compliance with the timing and methods of the process to overcome the crisis; the deviation cannot be absorbed by corrective actions and adjustment mechanisms, as they are not foreseen and/or not sufficient.

It should also be emphasised that a good monitoring process is not only a ‘mechanical occurrence’ linked to the production of reporting (scorecard) and the analysis of deviations (gap analysis). It is above all a cultural element because it implies accountability in the management of operational responsibilities, which represents a real organisational engine, an expression of fundamental leadership for every successful company.

Chapter 4

Common Characteristics of Firms in Financial Distress and Prediction of Bankruptcy or Recovery: An Empirical Research Carried out in Italy 1. Overview of Corporate Financial Distress and Bankruptcy (with a Special Focus on Italy) and ‘Early Warning’ Signs Evidence exists of notable corporate collapses, including those of WorldCom, Enron and Tyco. According to Cerved, in Italy, a total of 11,096 firms experienced a failure in 2019, representing a 1% decrease since 2018.1 The corporate health of firms is of considerable concern for various stakeholders, such as investors, managers, policy makers and industry participants. Nowadays, the main concern of companies, regardless of their size and sector, is the threat of insolvency. On the other hand, for company stakeholders, both internal and external, the priority is to identify any warning signals of the crisis before the company reaches the point of no return. Crises turning into insolvency create serious damage for workers, shareholders, savers, banks, suppliers, public administration and all the parties involved (Charalambous, Charitou, & Kaourou, 2000; Charitou, Neophytou, & Charalambous, 2004; Warner, 1977). All these actors should have the opportunity not only to detect the crisis warning signs but to reasonably foresee when the crisis may occur. In line with the relevance attributed to the stakeholders’ interest, the research output has been obtained by precisely following the perspective of the Stakeholder theory (Freeman, 1984; Donaldson & Preston, 1995) which considers the company from the point of view of the interested parties (both primary and secondary stakeholders). The evolution of these studies, focused on the prediction of insolvency, used statistical analyses of financial-economic indicators based on Probit analysis, neural

1

Cerved Group S.p.A. is the largest information provider in Italy and one of the major credit rating agencies in Europe.

Corporate Financial Distress, 67–99 Copyright © 2021 by Emerald Publishing Limited All rights of reproduction in any form reserved doi:10.1108/978-1-83982-980-220211005

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networks and other innovative methodologies (Bellovary, Giacomino, & Akers, 2007). A lot of analyses based on the use of statistical tools and on Altman’s original Z-Score model (1968) and its variants have attempted to refine forecasting accuracy. In Italy, several attempts have been made to adapt international works and also existing models (such as Argenti, 1976; Alberici, 1975). Despite developments in recent studies and research, well-founded analyses on multivariate discriminants continue to play a central role in predictive models of potential defaults. Bellovary, Giacomino, & Akers (2007), in their study, highlighted about 150 different types of predictive models, developed since 1965. Their analysis showed that many of the predictive models are effective at warning on insolvencies ahead of time, but the authors also stated that researchers are continuously developing new predictive models which describe a company’s possible insolvency and its overall implications. The scholars focused their attention on the effectiveness of the existing models. The first step in this direction involves verifying the degree of reliability and accuracy of the existing models. Literature has shown that existing models tend to lose their effectiveness when used on real samples which are different in size, sector, type, legal status, area of interest, etc. What has just been said can be confirmed if these models are used in different observation periods compared to the ‘test case’ originally used (Grice & Dugan, 2001; Grice & Ingram, 2001; Wu, Gaunt, & Gray, 2010). In this sense and more recently, numerous empirical research studies have been carried out with the goal of testing the effectiveness of the main models, with or without adaptation, using selected samples within specific national boundaries, even outside the North American or European context (Alkhatib & Al Bzour, 2011; Altman, Danovi, & Falini, 2013; Altman, Hartzell, & Peck, 1995; Cestari, Risaliti, & Pierotti, 2013; Charitou et al., 2004; Kovacova & Kliestikova, 2017; Peel, Peel, & Pope, 1986; Taffler, 1982). Several works were focused on the Italian context (Altman, 2013; Bottani, Cipriani, & Serao, 2004; Celli, 2015; Giacosa, Mazzoleni, Teodori, & Veneziani, 2015; Giacosa, Halili, Mazzoleni, Teodori, & Veneziani, 2016; Madonna & Cestari, 2016). If a model – which has been used in any context (regardless of the different observation periods, geographical areas, sectors, etc.) – proves to have a sufficient predictive power, the stakeholders will correctly use it to achieve their goals (Madonna & Cestari, 2016). In particular, some recent studies have investigated models used in banking systems where statistical analyses (such as logit regressions) are applied. Considering the difficulty of their application, they will not be dealt with in the current research.

2. The Company Recovery in Theoretical and Empirical Research Work As previously stated, economic science has mainly analysed corporate crises from the generic point of view, above all in recent years. The general belief was that

Common Characteristics of Firms in Financial Distress

69

crisis arises as the result of a process that has its own causes and which, through symptoms and signs, finally leads to economic and/or financial effects. Particular attention to the identification of the causes and the alerting signs at an early stage can allow for a timely turnaround that can steer the company back to recovery and health. The company’s strengths and weaknesses and the causes which led to its crisis need to be analysed through the lens of the balance sheet to identify the most suitable tool and solve the crisis. These aspects have long been the subject of attention from legal and economic scholars and professionals especially as far as concerns effective and efficient forecasting, prevention and management measures of the phenomenon (CNDCEC – AIDEA- ANDAF – APRI - OCRI, 2017; Danovi & Panizza, 2017; Ambrosini & Tron, 2016; Tron, Valenza, & Caputo, 2018). For some time, it has generally been accepted that avoiding an invasive judicial control during the recovery process could help secure the necessary resources to satisfy lenders more quickly and with better results. In the following sections, we will try to prove this assumption using evidence from some empirical researches on companies which have experienced a recovery. In particular, we will prove that the financial aspects have to be examined, as they are the easiest to be detected and measured, although they are not at the origin of the crisis.

3. An Empirical Analysis by the University of Pisa in 2012 on the Correlation between Financial Flows and Economic Performance (as a Predictive Element of the Crisis) In a research study carried out in 2012 by the University of Pisa in collaboration with ANDAF (Associazione Nazionale Direttori Amministratori Finanziari – Italian Financial Executives Association) (Allegrini, Tron, Greco, & Fieramosca, 2012; Tron & Greco, 2012), on a sample of 52 industrial and service companies featuring the worst performance (hereinafter called ‘worst performing’) listed on the Italian Stock Exchange (Borsa Italiana S.p.A.), an attempt was made to test if the financial flows could provide valid information on future economic performance. A sample of the worst performing companies was taken on the basis of five parameters: ROS, ROE, ROA, market value and turnover, during the period 2006–2009. After creating five rankings (‘clusters’) of Italian listed industrial and services companies, from worst to best for each of these parameters, those with the largest number of ‘presences’ in the rankings were selected. Almost all the selected companies were present in all the rankings and in the worst position. The selected companies represent various product sectors: 67% are from the manufacturing sector and 33% belong to the service supply sector. Furthermore, the sample is made up of medium-large (40%) and large (60%) companies.

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For the period 2004–2009, we collected data on the following cash flow configurations:

• • • • •

working capital flow (FCC); change in net working capital (VCCN); cash flow from typical operations (FCGC); cash flow from operating activities (FCGO); cash flow from investment activities (FCIs).

The correlation analysis was subsequently limited to changes in cash flows for the period 2004–2007 in order to analyse their relationship with the profitability of the years 2008–2009. For each of the flows, between 2004 and 2007, the average annual variation was calculated. Here is an example of the analysis carried out on two different companies (Table 4.1). The final step of the research consisted in studying the correlation between the average of the annual change in the flows, in the period 2004–2007 and the variables of profitability (ROE, ROA, ROS) and market value for 2008 and 2009. The aim, as mentioned above, was to evaluate whether the trend of cash flows has a predictive value with respect to the company’s future profitability. The analysis was conducted using Spearman’s rank of statistical correlation method (Gujarati, 2004). The examined correlations are shown in the following tables (Tables 4.2 and 4.3):

Table 4.1. Analysis of the Cash Flow Statements of the Sample Companies. Company Year Circulating Circulating Management Operating Investment Flow Variation Cash Flow Cash Flow Flows

1

2

2004 68,798 2005 68,146 2006 62,360 2007 80,091 2008 63,890 2009 61,206 2004 71,225 2005 66,932 2006 39,589 2007 22938 2008 2117222 2009 237776

4,779 140,755 226168 225873 30,428 27662 2109062 141,840 81,997 10,338 57,758 222222

73,577 208,901 36,192 54,218 94,318 53,544 237837 208,772 121,586 7,400 259464 259998

49,800 56,174 45,313 58,367 86,571 55,784 118,533 118,367 2163749 2217823 21037 253903

236186 242863 255841 284324 288735 2133244 74,073 236,368 155,398 352,011 225738 23,158

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Table 4.2. Correlations between Financial Flows and Examined Profitability Ratios. Average of Variations for 2004–2007 of the FCC

Average of variations for 2004–2007 of the VCCN Average of variations for 2004–2007 of the FCGC Average of variations for 2004–2007 of the FCGO Average of variations for 2004–2007 of the FCP

ROS Average for 2008–2009

ROA average for 2008––2009 ROE average for 2008–2009 MV value for 2008 MV value for 2009

Table 4.4 shows how positive flow trends of working capital are positively associated with all the indicators of average profitability (ROS, ROA and ROE) for the two-year period (2008–2009) and with the market value. The coefficient of determination (variable from 0 to 1) indicates the correlation level; the p-value points out the significance. The variation in net working capital is negatively correlated with some variables, and the result presents a high degree of confidence for ROS and ROA (Table 4.5). An expansion of net working capital was therefore negative for profitability during the crisis years. This is not surprising: expansion of working capital on the one hand absorbs the resources generated by the core business while, on the other hand, the absence of an adequate growth reveals the difficulty in creating a closely functioning relationship with customers and suppliers to correctly manage stock rotation. Basically, the uncontrolled growth of working capital is a symptom of deterioration of the operational performance, which can quickly be transmitted to the company cash flow dynamics (and therefore, to liquidity). The research shows that the trend of the working capital flow from 2004 to 2007 is correlated with the performance indicators and with market value for 2008 and 2009. The sample of listed companies which in the past reported negative trends in their working capital flows also featured the worst results when compared to the other listed companies. Positive trends in working capital flows are positively associated with average ROS, ROA and ROE of the two-year period 2008–2009 and with market value. The trend in the working capital flow probably best expresses the economic performance of the company’s core business. A good result – in the years before the crisis – has allowed the better performing companies to maintain their profitability during the crisis period.

72

ROS ROA ROE MV2008 MV2009 a

FCC

VCCN

FCGC

FCGO

FCI

0.37966362a 0.39725092a 0.31375395a 0.32143772a 0.25971143a

20.29736191a 20.42064373a 20.22812260 20.13788099 20.14513788

0.20840092 0.12891659 20.09152224 20.02834457 20.00913515

0.17186033 0.11448818 20.08674123 20.02313669 0.03918723

20.17211645 20.17681209 20.03679672 20.10415777 20.16127380

Coefficient of Determination with a high confidence interval.

Corporate Financial Distress

Table 4.3. Correlations Highlighted by the University of Pisa/ANDAF’s Research.

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Table 4.4. Correlations between Working Capital Flow (2004–07) and Average Values of Profitability and Market Value Indices (2008–2009). Variable

ROS (average 2008–2009) ROA (average 2008–2009) ROE (average 2008–2009) Market value 2008 Market value 2009

Determination Coefficient

Significance (p value)

0.379 0.397 0.313 0.321 0.259

0.0067 0.0046 0.0250 0.0217 0.0636

Table 4.5. Correlations between Net Working Capital (2004–2007) and Profitability Indices (2008–2009). Variable

ROS (media 2008–2009) ROA (media 2008–2009) ROE (media 2008–2009) Market value 2008 Market value 2009

Determination Coefficient

Confidence Interval

0.29736191 0.42064373 0.22812260 0.13788099 0.14513788

0.0337 0.0027 0.1033 0.3248 0.3000

Once again, the data are confirmed by the change in the net working capital: its excessive growth, if compared to the decrease in the core business cash flows (cash flow from operations), is correlated to poor performances during the crisis period.

4. Empirical Analysis by the University of Pisa in 2013 on: (a) Cash Flow and Correlations with the Economic Performance of Italian Listed Companies and (b) Predictive Capacity of Past Operating Cash Flows and Profits over Future Operating Cash Flows and Profits The empirical research undertaken by the University of Pisa in collaboration with ANDAF in 2012 was applied in 2013 to the same sample of companies listed on the Italian Stock Exchange (BorsaItaliana S.p.A.), extending the correlation of financial flows – recorded in the period 2004–2007 – with the average economic performance values of the 2010–2011 period (Tron & Greco, 2013). The correlation values, using Spearman’s analysis, as in the 2012 research, were reinforced by the 2013 empirical analyses on the average profitability values recorded in years 2010–2011, as illustrated in the following tables (Tables 4.6 and 4.7).

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Table 4.6. Correlation between Net Working Capital (2004–2007) and Average Profitability Indices (2010–2011). Variable

Determination Coefficient Confidence Interval

20.438 20.387 20.400 20.298 20.293

ROS (average 2010–2011) ROA (average 2010–2011) ROE (average 2010–2011) Market value 2010 Market value 2011

0.00 0.00 0.00 0.03 0.03

Table 4.7. Correlation between Net Working Capital (2004–07) and Precise Profitability Indices (2010–2011). Variable

ROS 2010 ROS 2011 ROA 2010 ROA 2011 ROE 2010 ROE 2011

Determination Coefficient

Confidence Interval

20.407 20.364 20.389 20.283 20.216 20.425

0.0036 0.0092 0.0054 0.0428 0.1228 0.0024

The results indicate that net working capital is negatively correlated with some profitability variables with a higher degree of confidence for the average ROS and ROA for the two-year period 2010–2011 and a lower confidence degree for the ROE and the average market value for the two-year period 2010–2011. In this case, expansion of working capital in the sample of companies under examination is negatively related to sales and asset profitability in following years. It should be noted that in both research studies conducted by the University of Pisa/ANDAF in 2012 and 2013, the examined sample was composed of 52 companies. To obtain wider results, it would have been necessary to consider all the companies listed on the Italian Stock Exchange, but the evidence presented here is however interesting. Another research carried out in 2013 by the University of Pisa in collaboration with ANDAF concerned the analysis of economic performance and financial flows in the field of industrial and service companies between 1998 and 2011. The selection involved a sample of 528 companies extracted from Worldscope with the available data (over 5,600 observations) and analysed the correlation through some tests carried out under the observation periods 1998–2004 and 2005–2011.

Common Characteristics of Firms in Financial Distress

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The test of the predictive ability of operating cash flows and profits versus the future operating cash flow (‘OCF’) was carried out by studying the association between the current OCF and the OCF added to the profits of previous years, using regression analyses and R-Square calculation. In order to assess the predictive capacity of operating cash flows and profits with respect to future operating cash flow, the association between operating cash flow and operating cash flows of the previous three years has been studied by taking into account the same cash flows both individually and jointly.

Operating cash flow at time t-1, t-2, t-3 Operating cash flow Profit at time t-1, t-2, t-3

The following models have been estimated: (a) in models 1 to 3, operating cash flow has been associated with the operating cash flow of the three previous years. Models 1a, 1b, 1c. OCFit5 b0 1 b1OCFt2 1….t23 1 «it In model 2, operating cash flow has been associated with cash flow of the three years taken together. OCFit5 b0 1 b1OCFt211 b2OCFt221 b3OCFt231 «it The same models are used having the net profit as a dependent variable (net profit from separate income was used for the IAS/IFRS financial balance sheet). Models 3a, 3b, 3c. OCFit5 b0 1 b1PROFITt21….t23 1 «it Model 4 OCFit 5 b0 1 b1 PROFITt211 b2 PROFITt221 b3 PROFITt231 «it With the same logic, the predictive ability of future net profit and future operating cash flows. Models 5a, 5b, 5c. PROFITit5 b0 1 b1OCFt21….t23 1 «it In model 6, net profit is placed in relation with the cash flows of the three years together. PROFITit5 b0 1 b1OCFt211 b2OCFt221 b3OCFt231 «it The same models are used with net profit as a dependent variable (net profit from separate income was used for the IAS/IFRS financial balance sheet). Models 7a, 7b, 7c. OCFit5 b0 1 b1PROFITt21….t23 1 «it Model 8 PROFITit 5 b0 1 b1 PROFITt211 b2 PROFITt221 b3 PROFITt231 «it

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Table 4.8 shows the results of the analysis of the predictive ability of operating cash flow and profits compared to the operating cash flow in the period 1998–2004. In general, the analysed correlation between OCF and profit appears stronger for the oldest data. This may be related to the fact that older data express higher variability; however, it is worth noting that this does not always happen. The operating cash flow seems to work better as a predictor, in the short term, if compared to the future operating cash flow, as shown by the R-Squares of models (1a) and (1b) with respect to (3a) and (3b) in Table 4.8. In the long run, profits and operating cash flow tend to have a similar predictive ability; this can be deduced from the R-Square compared to the lagged data (Borden, Hensley, & Hertzke, 2016; Larsen, 2012) for 3 years (Table 4.8, Model 1c and 3c) and R-Square of the combined model (Table 4.8, Model 2 and Model 4). Table 4.9 shows the same analysis carried out for the period 2005–2011. In the IAS/IFRS setting, the operating cash flow appears to have a slightly higher predictive ability, both in the short and long term, in relation to future cash flows, if compared to profits. Table 4.9 shows that the R-Square of the models that have the operating cash flow as an independent variable are generally higher than those that have net profit as their independent variable. Compared to the pre-IAS/IFRS accounting context, both the operating cash flow and the profits seem to have lower predictive ability in relation to future operating cash flows.

Table 4.8. Analysis of the Predictive Ability of Operating Cash Flow and Profits in Relation to Operating Cash Flow in the Period 1998–2004. Dependent Variable: Operating Cash Flow at Time ‘t’. Models

Model 1a Model 1b Model 1c Model 2

Adj R-square

OCF t21

0.58

OCF t22

0.63

OCF t23

0.66

OCF t21…23

0.71

Adj R-square

Model 3a Model 3b Model 3c Model 4

PROFIT t21

0.54

PROFIT t22

0.59

PROFIT t23

0.68

PROFIT t21… 23

0.72

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Table 4.9. Analysis of the Predictive Ability of Operating Cash Flow and Profit in Relation to Operating Cash Flow in the Period 2005–2011. Dependent Variable: Operating Cash Flow at Time ‘t’. Models

Model Model Model Model

1a 1b 1c 2

OCF OCF OCF OCF

t21 t22 t23 t21…23

Adj R-square

0.56 0.62 0.67 0.70

Adj R-square

Model Model Model Model

3a 3b 3c 4

PROFIT t21 PROFIT t22 PROFIT t23 PROFIT t21…23

0.51 0.55 0.63 0.66

Table 4.10. Analysis of the Predictive Ability of Operating Cash Flow and Profits in Relation to Operating Cash Flow in the Period 1998–2004. Dependent Variable: Net Profit at Time ‘t’. Models

Model Model Model Model

5a 5b 5c 6

OCF OCF OCF OCF

t21 t22 t23 t21…23

Adj R -square

0.48 0.53 0.56 0.60

Adj R-square

Model Model Model Model

7a 7b 7c 8

PROFIT t21 PROFIT t22 PROFIT t23 PROFIT t21…23

0.51 0.57 0.55 0.62

Table 4.10 shows the predictive ability of operating cash flows and profits compared to future profits. In general, the predictive ability of operating cash flow and net profit, if compared to the future net profit, looks very similar, with very close values. The following Table 4.11 shows the predictive ability of operating cash flows and profits compared to future profits in the IAS/IFRS setting. In the IAS/IFRS situation, operating cash flow appears to have a greater predictive ability than the OCF as far as the future profits are concerned. The combined predictive ability of the operating cash flow for the previous three years varies from 0.70 (Table 4.10, Model 6) to 0.51 (Table 4.11, Model 6). The combined predictive capacity of the profits for the previous three years ranges from 0.62 (Table 4.10, Model 8) to 0.45 (Table 4.11, Model 8).

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Table 4.11. Analysis of the Predictive Ability of Operating Cash Flow and Profits in Relation to the Operating Cash Flow in the Period 2005–2011. Dependent Variable: Net Profit at Time ‘t’. Models

Model Model Model Model

5a 5b 5c 6

OCF OCF OCF OCF

t21 t22 t23 t21…23

Adj R-square

0.41 0.48 0.46 0.51

Adj R-square

Model 7a Model 7b Model 7c Model 8

PROFIT PROFIT PROFIT PROFIT 23

t21 t22 t23 t21…

0.38 0.43 0.42 0.45

The second research study highlights the importance of reporting, as concerns the financial flows, considering their predictive value on the company’s future economic and financial progress. In particular, for the listed companies, it has been observed how, in the years when international accounting standards were applied, the operating cash flow has a higher predictive capacity on the future economic and financial trends if compared to net profit. When the national accounting principles were applied, on the contrary, the higher predictive capacity is limited to the short term and does not affect the medium-long term. It is also observed that, in general, the predictive ability of both the operating cash flow and profits is generally reduced after the adoption of international accounting standards. Among the hypothetical causes, there is the greatest volatility of some costs and income components in the income statement in the IAS/IFRS (e.g., consider the impairment charges with respect to the amortisation of goodwill). The literature highlights how prudence and accounting conservatism generally allow a greater ability to predict future trends. In the IFRS case, obviously, these balance sheet features are considered less important than competence and current values. One cannot exclude that a reduction in predictive ability is linked to the increased volatility of results due to the crisis, which may have reduced the statistical association between current data and data from previous years. The main drawback of this research lies in the size of the examined sample, both in relation to the number of sampled companies and with reference to time series, within IAS in the periods following the 2008 global financial crisis.

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5. Corporate Crises, Weak Signals and Debt Restructuring: An Empirical Analysis in 2014–2015 by Bocconi University and SDA Bocconi As already mentioned, for some time scholars have dealt with the issue that necessary valuable resources could be released much more quickly by avoiding invasive control in the judicial phase. The extrajudicial renegotiation, which offers a lot of a possibilities depending on the different sorts of companies involved, represents a flexible tool allowing the business owner to attempt alternative solutions to bankruptcy, both through the restructuring of liabilities, and through the preparation of a turnaround plan (Franceschi & Tedeschi, 2014). It is important to highlight that extrajudicial renegotiation should be easier to achieve if the company is in the early stages of the crisis and has not yet experienced any serious consequences necessitating one of the judicial tools provided by bankruptcy law. A research study carried out by Bocconi University in 2014 (Dallocchio, 2014) had the goal of identifying the signs that are likely to lead to a debt restructuring phase and determining the drivers of a successful restructuring process. The sample used in the empirical analysis consisted of 426 companies which, during the period 2007–2013, undertook at least one of the available restructuring procedures (debt restructuring agreements pursuant to art. 182 bis l.fall., arrangement with creditors pursuant to art. 160 et seql.fall., extraordinary administration and agreed bankruptcy). The results of their analysis contain some interesting aspects:

•

• •

the first weak signs of the crisis may already be identified in the three/four years preceding the start of the procedure and are characterised by non-physiological values of financial indicators and, in particular, the relationship of financial debt due to a ‘wild’ growth of working capital, to increases in stocks and in the average days of sales outstanding (DSO) together with reduction of the average payment periods. It is clear that suppliers are those who notice the first symptoms of difficulty occurring, while the lending banks usually are not so quick to realise there is tension. actually, there is an increase in short-term debt, in particular towards banks, due to the inability to find resources with long due terms. This creates a temporal imbalance between financial resources and investments that can provoke a liquidity shortage and affect business continuity. companies which overcome the crisis, then, usually feature a very limited financial elasticity – in their post-restructuring phase – with a slow and gradual return to profitability.

To summarise the achievements, the 2014 research study conducted by Bocconi proved that the tools to manage the crisis have generally worked. In any case, results are particularly related to the timeliness with which they are implemented (Dallocchio, 2014).

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Timely actions, once the real signs of instability have been detected, may be effectively pursued through the monitoring of simple indicators (indices and cash flows). Finally, the research states that in order to break the vicious circle leading to business crises, in our country, we should move along the following directions:

• • •

foster the growth in size of companies; strengthen their financial structure by rebalancing financial sources (the relation between equity and debt capital), and the diversification of debt sources and their rescheduling (with longer due dates); pursue research and innovation and favour market internationalisation.

It is clear that the first assumption is key to achieve the other two. A later research study on the topic by SDA Bocconi in 2015 (Danovi, Conca, & Riva, 2016), in collaboration with the most relevant law courts in Northern Italy, and having as an observation period the years 2005–2014, simply confirms what has been stated above. In particular, from the point of view of debtor companies, all successful recovery processes present the following features:

• • •

changes in the organisation; effective cost reduction measures; a focus on the main/core business.

However, it should be noted that, in general, most debtor companies leave the recovery process still having a high leverage (Danovi et al., 2016). The research reveals that, the incubation period of the crisis takes – on average – two years, from the failure occurring to the drafting of the recovery plan. Furthermore, most companies show heavy imbalances and a high risk of insolvency up to five years before the adoption of bankruptcy law measures. Failure to intervene at least three years before the crisis is manifested greatly reduces any chance of a successful restructuring. The study then considers that the D/E and D/EBITDA ratios remain very high even in the year in which restructuring occurs (and not only in the years from t-3 until year t of restructuring). The data explain the prevalence of actions aimed at delaying debt due dates owing to the poor capacity to pay it back. The relevant number of companies with negative Equity and EBITDA in the years preceding t reinforces the evidence that interventions are generally not taken early enough (Danovi et al., 2016). Nevertheless, this empirical evidence shows how, among all the interventions, financial debt write-offs are predominant, in the form of incremental contributions by the stakeholders, while the banks’ support – in terms of new finance and capital conversion – takes place only in 20% of cases. On the asset side, however, the research showed that:

•

the sale of real estate assets was the most common action envisaged in the plan (although not the fastest one to collect liquidity, owing to the sector crisis);

Common Characteristics of Firms in Financial Distress

•

81

the sale of equity investments and business branches occurred with a view to reorganising the core business.

Moreover, from the analysis, two other main factors emerged, and they are of particular relevance to business owners:

• •

industrial interventions focus mainly on the reduction of structural costs and only marginally on the rationalisation of production (internalisation, outsourcing, offshoring), expansion of exporting and external growth strategy; as far as governance is concerned, managerial and corporate discontinuity occurred only too rarely (less than a quarter of the operations led to a change of more than half of the members of the Board of Directors and only in a very few cases was the CEO replaced; in 80% of cases the corporate structure remained stable, the presence of a Chief Restructuring Officer – CRO – was reported in rare cases).

In the reorganisation/restructuring operations which have been analysed, the deferral of interest was not sufficient for the success of the turnaround process, whereas deferment of capital repayment proved to be more effective. A more incisive intervention, as it is logical to expect, relates to credit writeoffs. This is often associated with the involvement in the recapitalisation of the company through credit conversion. This result appeared consistent with what was observed by qualified scholars (Asquith, Gertner & Scharfstein, 1994), who highlighted how banks are more eager to write off residual debts where procedures take place under the protection of law courts (Danovi et al., 2016).

6. Business Administrative Systems (BAS) and Bankruptcy Financial Distress (Based on the Observatory on Corporate Crisis – OCI Survey (2011)) A research study carried out in 2015–2016, by Bologna University and Pisa University (Paletta, Alimehmeti & Tron, 2016), shows that business administrative systems (BAS) is commonly considered to be a condition that improves the economic efficiency of firms. This study is based on the survey conducted in 2011 by the Observatory on Corporate Crisis (OCI) in relation to the verification of the passive state of bankrupt companies and provides empirical evidence to test the research questions. The survey contains the profiles of governance and management of bankrupt companies, as well as the causes and circumstances of the distress (Bastia, Ferro, & Nonno, 2011). A total number of 668 questionnaires were collected and were related to bankruptcies declared between January 2008 and October 2010, pertaining to 51 courts in 20 Italian regions collected during the survey. The sample included in 258 individual companies and 410 joint-stock companies.

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For 384 of the total 668 bankruptcy procedures, it was possible to obtain the financial statements data and other information on companies from the Bureau Van Dijk AIDA database that contains comprehensive information on companies in Italy, with up to five years of history. Literature considers BAS as a set of tools, methods and structures that support management in the continuum of decision-making, monitoring and reporting. It includes, therefore, planning and control (plans, budget, cost accounting, reporting), financial analysis and management (cash and credit management, investment, funding), organisational arrangements (organisation charts, job descriptions, operative procedures, etc.) and the organisational structure of the Chief Financial Officer – CFO function (Anthony, Govindarajan, Hartmann, Kraus, & Nilsson, 1998; Chenhall, 2003; Merchant & Van der Stede, 2007). The arguments about the positive effects of BAS have been developed largely with reference to either healthy companies or companies in crisis that thanks to the most advanced management systems are able to pre-empt the effects of crises by successfully launching a restructuring process (Mckinley, Latham, & Braun, 2013). However, we have little knowledge on the role of BAS in companies in bankruptcy. The objective of the mentioned research was to begin to fill this gap by analysing the effect of BAS on the severity of the damage (Trahms, Ndofor, & Sirmon, 2013). Focus was given to the characteristics of BAS and its indirect and direct effects on failure severity and durability. According to the current literature, we expect that companies with more evolved BAS are more durable and able to mitigate the economic and financial effects of bankruptcy, reducing the level of debt in proportion to the invested capital. The effects of more evolved BAS can be assumed as direct and indirect, given the propensity to start a turnaround process and the debt restructuring of the company.

6.1 Reorganisation Strategies and Administrative Systems Sheppard and Chowdhury (2005) argue that the causes of corporate crisis generally do not reside only in the external environment or only in the organisation, but must be attributed to both these forces, with the consequence that the company’s crisis indicates essentially a problem of misalignment of the company with its competitive environment. In these terms, the crisis is by definition a crisis of consonance, on the one hand, between the corporation strategy and its external environment and on the other, between the corporation strategy and its organisational structure. As defined in the previous chapters, it follows that in order to implement longterm viability the restructuring processes should restore a double consonance: strategic and operational.

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Another line of research has analysed the turnaround processes distinguishing the content of the interventions (strategic vs operative) with respect to the enabling factors that can promote or prevent the launch and success of the turnaround. Companies should have the capacity to manage unpredictable situations and modify and review their own choices to be able to quickly change their strategies. This means they have to be able to think about change in an open way, trying not to suffer it but being able to manage it by exploiting all the opportunities it may offer. Changes therefore need a continuous monitoring in order to control the coherence with the formulated research questions in order to adapt the management to the variations which have taken place and so making strategy implementation and success possible (Fig. 4.1). Rapidity in strategy execution is key; this implies the capacity to integrate management by efficient control and evaluation processes able to grant the implementation and execution of the assumed strategic decisions. The choice of different business administration and reporting systems first requires an analysis of the features of the BAS made up of different elements:

Growth of Confidence and Availability of Resources for Development

Restoration of Financial and Economic Conditions

Strategic Turnaround

Operative Turnaround

Influencing Factors Ownership Structure Corporate Governance Leadership Management System

Fig. 4.1. Enabling Factors of the Processes of Strategic and Operative Turnaround. Source: Adapted from Paletta et al. (2016).

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data, information, technological and human resources, methodologies and tools to convert data into information (Ferri, 2006; Tron, 2009). The ex post evaluations, which normally most of the BAS supply, are oriented to observe the past; they cannot offer any support to the rapid evaluation of changing prospects and therefore to reorient the corporate strategic behaviour. The reporting controls remain, generally, focused on the operational implementation phase resulting from the decisional process and are therefore based on economic-financial information and on short-term accounting tools. It then becomes necessary to implement a BAS, like the ERP systems, thus enabling the management to control processes and activities rather than products (Druker, 1995; Tron, 2009). The implementation of control methodologies and tools needs to become an articulated and continuous process to support, on an ex ante vision, the rescheduling of the strategic decisions (Garzella, 2005; Tron, 2013). The critical success factors, in fact, are able to determine the success and profitability of competitive businesses, and they have to be analysed to capture the performances which are due to the alternation of the critical success factors and/or modification of their relative strategic weight (Galeotti, Garzella, Fiorentino, & Della Corte, 2016). Corporate doctrine has been principally focused on management turnover (leadership) and on corporate governance as enabling processes of turnaround, while in this study we focus on the business administration systems that are a part of the wider system of corporation governance and management (Greiner, 1967; Lenahan, 2011; Slatter & Lovette, 1999).

6.2 Business Administrative Systems in Financial Distress Situations One of the most important drivers of turnaround success is the ability of information systems to answer the call of new relevant data and monitoring corporate performances (Marchi, 1993). This request for data is increasingly related to the likelihood of supporting the strategic decision-making process (Galeotti et al., 2016; Mancini, Vaasen, & Dameri, 2013). Business Administrative Systems are considered a factor in the development of the company because they make management more effective when addressing, monitoring and incentivating the organisational behaviour (Paletta & Alimehemeti, 2016). BAS should be able to transform large amounts of information into decisions and policy actions and should operate on permanent data storage scanning information with continuity, regardless of the contingent need for information. The reliability of BAS helps to build confidence around the company, and, for some time, it may contribute to maintaining good relations with banks, suppliers and customers even if the administration shows some economic and financial imbalances (Merchant & Van der Stede, 2007; Paletta, 2008; Tron & De Giovanni, 2016).

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The high risk of dissolution that accompanies enterprise management during a crisis creates a clearly different perception of decision-making, and this cannot remain invariable without influencing the role of BAS and their use in crisis management (Lagadec, 1991a). The kind of organisational culture and the particular environment that is created during a crisis due to the pressure of stakeholders, can lead to improper and opportunistic use of BAS that ends up making the situation worse. In theory, depending on the organisational culture, it can be expected that the management control systems induce two types of opposing attitudes, but both deleterious from the point of view of bankruptcy effects. Firstly, stable corporate and conservative cultures appeal to administrative systems to develop internal business plans and propose arrangements for debt restructuring. The degree of objectivity of such plans may be affected by the fact that the management is based on traditional methods of decision-making and control, and often accompanied by previous well-known and condescending business consultants, rather than relying on radically new points of view coming from new expert consultants in corporate crisis management (Tron, 2013). In this sense, the administrative systems are deeply rooted in managerial practices, and may be proved to be a factor of inertia to change; a cultural border to conventional ways of dealing with problems. The consequence is that the management can be induced to take less innovative or radical decisions than in the past, justifying the attitudes of closure instead of making a serious and informed analysis of the causes of the crisis and pursuing strategies that would be needed to cope with it.

6.3 Results The research questions that include the bankruptcy, organisational, governance, performance and control variables are shown in the following table (Table 4.12): The first model analysed examines the relationship between restructuring strategies, business administration systems and the severity of failure (PPC) measured by the PPC ratio. We account for both direct and indirect effects. An increase of the PPC indicates higher debts than capital invested expressive of the negative effects of bankruptcy. Restructuring strategies and management and control systems have a negative relationship with PPC. For every increase of each of the two latent variables, Control sys and Restructuring, the PPC is reduced, respectively, 20.859 and 27.728. The relationship with restructuring strategies shows a stronger relationship than management and control systems, but nevertheless, the two coefficients are not statistically significant. With regard to the range of activities (administrative, financial and management control) carried out by the CFO function, there is a positive relationship between PPC and the administrative activities equal to 0.297.

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Table 4.12. Variable Description. Dependent PPC Durability/Age Bankruptcy RESTRUCTURING YEARS_CRISIS

Organisational CONTROLSYS

ADMINISTRATIVE ACTIVITIES FINANCIAL ACTIVITIES

CONTROL ACTIVITIES

Governance CFO SOLE_DER BOD BOA NO_CEO

(Liabilities – Equity)/Invested Capital (data from AIDA) Calculated as the number of years from the registration date. Latent variable which, accounts for the presence of pre-pack plans. Latent variable. Following the approach of Daily (1996), we calculate the crisis year as the year of decline of the following indexes: ROA; Debt/Equity; Current Ratio Latent variable which accounts for the presence of management and control systems (see Table 4.4) 1 if the firm holds its accounts, prepares its the financial statements; 0 if it needs external consultants. 1 if in addition to the ADMINISTRATIVE_STR, also performs tax compliance by itself and submits periodic statements; 0 otherwise. 1 if in addition to the FINANCIAL_STR, the firm does Managerial accounting and reporting; 0 otherwise 1 if there is a CFO; 0 otherwise 1 if the firm has a sole director; 0 otherwise 1 if the firm has a board of directors; 0 otherwise. 1 if the firm has a board of auditors; 0 otherwise 1 if there is no director; 0 if there is at least a director.

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87

Table 4.12. (Continued) Performance ROA Control Variables SIZE NORTH SECTOR

Return on assets measured as the ratio of EBIT on total assets Calculated as the natural log of total assets 1 if the firm is registered in North Italy; 0 otherwise. A set of dummy variables created from the ATECO codes.

Source: Adapted from Paletta et al. (2016).

This result shows that firms that carry out general accounting activities worsen the effects of failure, increasing the burden of debt on the capital invested. Other configurations of the type of activities held by the firm are not significant. One possible explanation for this effect is that companies that carry out by themselves all the main functions related to the collection, processing and communication of accounting information have the opportunity to exercise a greater control over the internal procedures aimed at the preparation of the financial statements. During a crisis, the presence of external consultants can help the entrepreneur to gain a more realistic and balanced perspective on the company’s current financial position. On the other hand, a company that self-manages the administrative processes during a period of crisis could take a self-serving approach that through opportunistic and fraudulent behaviour exacerbates the negative effects of bankruptcy. It is important to note the positive relationship between the activities and the tools of management and control. Firms that include different types of administrative, financial and control activities have a positive relation with the use of advanced tools such as management accounting. In addition, the management and control systems have a positive relationship with the governance structure. The presence of a Board of Statutory Auditors and a Board of Directors increases the use of the management and control tools by respectively 0.44 and 0.18. On the contrary, the absence of management decreases the use of the instruments of administration and control by -0.03. These results meet initial expectations. Restructuring strategies are positively related with the tools and activities of administration and control. The positive relationship with the management and control systems indicates that for every tool that is used by the enterprise, regeneration strategies increase by 0.12. In addition, the positive relationship with the activities of administration and control indicates a greater interdependence,

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moving from simpler structures (administration), to more advanced ones (control). Respectively, the coefficients are 0.015, 0.02 and 0.037. On the other hand, the restructuring strategies undertaken by bankrupted companies are consistent with more advanced company profiles, characterised by the presence of a board of auditors and a board of directors. With regard to the indirect effects, the theoretical assumptions underlying this study foresaw a brokerage role of restructuring strategies between business administration systems and the severity of the disruption. Firms with a more advanced BAS should show greater reactivity during a crisis of enterprise, engaging in operations of financial and productive economic restructuring designed to manage financial difficulties. Confirming the initial research question, this research demonstrates the existence of a positive relationship between restructuring strategies and business administrative systems. Firms with advanced systems appear to be more willling to opt for restructuring strategies as a way of dealing with crisis. However, the results are not statistically significant and therefore the results cannot be generalised. On the other hand, the research findings suggest that legal proceedings in corporate crisis management, including in particular the restructuring strategies, should further enhance the role of the administration and control systems, providing incentives to companies which adopt more advanced systems in order to mitigate the negative effects of bankruptcy. This is relevant, for example, in the examination of proposals when it comes to ‘white restructurings’, for which there is no plan and therefore no actual restructuring agreement. Companies in crisis with more administrative and advanced monitoring systems demonstrate a greater reliability and therefore appear more meritorious to access a protected institutional environment from individual executions exercised by creditors.

7. Innovative Empirical Research by Bocconi University and Parthenope University in 2018 on Corporate Recovery over a 10-year Observation Period (2007–2016) The research, carried out in 2018 by Bocconi University and Parthenope University (Dallocchio, Ferri, Tron, Vizzaccaro), in partnership with one of the main national banks, had the objective of investigating the common elements in successful recovery processes, in order to predict the outcome of a certain type of recovery operation and analyse some specific features (whether they were present or not) at the beginning of the restructuring phase. Often, also at an international level, restructuring operations seem to generate positive short-term results, although this does not produce any lasting and sustainable performance in the medium and long term. Similarly, Altman, analysing US companies, revealed that 32% of the companies going through specific

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89

bankruptcy procedures under the US Law, ended up entering into a new procedure in the following four years. Altman and other authors also pointed out how these companies, once they concluded the procedure, still had poor economic and financial parameters and were not dissimilar to companies in default. These results, as well as the process effectiveness and efficiency, do not depend only on the rehabilitated company but also on the sector it belongs to and on the overall economic situation (Altman, 1993; Altman, Malgorzata, Laitinen, & Suvas, 2017). As already mentioned, the goal of the research carried out in 2018 was to investigate the determinants of successful operations. By success, we mean the ability to pay back the outstanding debt (including debts towards the bank system) and to maintain a sustainable condition of going concern, so as to avoid another bankruptcy procedure. After a deep analysis of the reference bibliography, the authors did not find any study on the qualitative factors determining the success of corporate restructuring operations on the Italian market. The research started with the definition of a unique sample: the method for determining the sample represents one of the main innovative elements of the research. There is a complete lack of available data for business restructuring processes, as well as for extrajudicial restructuring (since it is of a private nature) and for judicial processes, and it is particularly hard to get qualitative information on the process management. Thanks to the support of a major banking institution primarily operating in Italy, though with a strong international presence, the authors managed to get hold not only of economic data and financial statements concerning the restructured companies but also of relevant qualitative elements leading the operative phases. A sample of 232 business cases was selected from the companies for which information was made available (Table 4.13). Two further samples were identified out of the sample of restructured companies as they responded to the research-selected criteria. The characteristics of each sample are briefly described here below.

•

Sample 1 (Firms in financial distress that have succeeded in restructuring): companies which, starting from 2014, after a ‘recovery’ procedure (not necessarily, a judicial one), show positive results, from the creditors’ perspective (the bank). 79 companies were ‘mapped’ and, out of these, 72 offered ‘valid’ data.

Table 4.13. Headquarters of the Companies Included in the Sample. Italian Companies

210

International Companies

Total

22

232

90

• •

Corporate Financial Distress Sample 2 (Firms in a financially sound position): companies which, in the period 2007–2016, did not present any economic and financial critical situations and were not submitted to any judicial or extra judicial recovery procedure. A group of 72 units was identified. Sample 3 (Firms which have failed): companies which ceased their activities (insolvency, voluntary or judicial liquidation, dissolution) in the period 2014–2016. 76 companies were grouped in this sample.

The total sample, consisting of the three sub-samples, is therefore composed of 220 companies: all their economic and financial data, for the period 2007–2016, were known. The three samples, constructed as explained above, are fully representative of the analysed companies. The average trends of the sub-samples in the period 2007–2016 are reported below. The main variables assessed are: the EBITDA Margin, ROS, ROA, D/E: the samples show a consistent trend. Management efficiency, defined as ROS, appears consistent with the average characteristics of the companies belonging to the clusters considered, with higher margins for healthy businesses, lower for rehabilitated ones (and growing since 2014 – the year in which they concluded their crises) and generally negative for the companies which ceased trading (owing to insolvency or even voluntary liquidation) (Fig. 4.2). The asset ability to produce income, expressed by ROA, appears consistent with the average characteristics of the companies belonging to the considered clusters, with higher results for healthy companies (about 19%), lower for the restored ones (approximately 13%), generally negative for companies that have ceased their own business (Figs. 4.3 and 4.4).

ROS (average; %)

10,00 8,00 6,00 4,00 2,00 0,00

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

-2,00 -4,00 -6,00

Firms financial distressed restructured

Fig. 4.2.

Firms in financially sound position

Firms which have failed

ROS Trend (%) for the Companies Included in the Different Samples.

Common Characteristics of Firms in Financial Distress ROA (average; %)

91 15,00 10,00 5,00 0,00

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016 -5,00 -10,00 -15,00 -20,00

Firms financial distressed restructured

Fig. 4.3.

Firms in financially sound position

Firms which have failed

ROA Trend (%) for Companies Included in the Different Samples. D/E (average; %)

2007

2008

2009

2010

Firms financial distressed restructured

Fig. 4.4.

2011

2012

2013

2014

Firms in financially sound position

2015

2016

45,00 40,00 35,00 30,00 25,00 20,00 15,00 10,00 5,00 0,00 -5,00 -10,00

Firms which have failed

D/E Trend for the Companies Included in the Different Samples.

Debt ratios also reflected the severity of financial stress, which may be very or slightly serious:

• • •

Average D/E of firms in a financially sound position (2007/2016): 1.43 Average D/E of firms in a financial distress that succeeded in restructuring (2007/2016): 6.44 Average D/E of firms which have failed (2007/2016): 9.29

Once the descriptive statistics were elaborated, correlations were analysed. To develop an assessment based on a known and reliable model, we used the Z-Score (in its original formulation and in a ‘revised’ version which will be discussed later), to get some results which could be compared to the analyses previously obtained by national and international researches. The investigation revealed the existence of some significant correlations, as summarised below. They are also useful to direct the next regression analysis (Table 4.14 and Fig. 4.5).

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Table 4.14. Correlation Analysis and Following Regression Analysis Carried out on the Selected Sample. Variable

Company status Company status Company status Company status Company status Company status Company status Company status Company status Company status Company status Company status Company status Company status

Variable

N (Number of Observations)

Positive or Negative Relationship

No. of board members (2007–2011) No. of CEO (2015–2018)

220

2

220

2

220

1

220

1

220

1

220

2

220

1

No. of Sole Directors (2007–2011) No. of Sole Directors (2015–2018) No. of Liquidators (2015–2018) President of BoD (2015–2018) Sole Directors average term of office Board of Directors average term of office Z-score (2007–2011)

220

1

220

2

Z-score (2012–2014)

220

2

Z-score (2015–2016)

220

2

Z-score (2007–2011) Revised Z-score (2012–2014) Revised Z-score (2015–2016) Revised

220

2

220

2

220

2

Consistent results were obtained under different Z-Score configurations for the period we chose to observe. For all the sub periods analysed, a significant negative relationship persisted between the score value and the company status. This is consistent with the conceptual setting of the score: the higher the scores, the lower the company’s probability of becoming insolvent.

93

Common Characteristics of Firms in Financial Distress Debt/Ebitda (average; %)

2007

2008

2009

2010

Firms financial distressed restructured

Fig. 4.5.

2011

2012

2013

Firms in financially sound position

2014

2015

2016

36,00 31,00 26,00 21,00 16,00 11,00 6,00 1,00 -4,00 -9,00 -14,00

Firms which have failed

Debt/EBITDA Trend for the Companies Included in the Different Samples.

The state of the company is represented by the dummy variable (0 5 healthy company; 1 5 company recovered or ceased), and its correlation with the score, seems to confirm this hypothesis. Once the correlation analysis was carried out, all the significant correlating variables were included in two models: (1) a first model includes the Z-Score in its original formulation; (2) a second model includes the Z’-Score in its revised version. Before proceeding with the analysis of the two chosen models, it is important to see – as shown in the following table – which is the outcome of the analysis on the 220 companies in the 2007–2016 period and the related performance of the Z-Score. Model 1 confirmed the relationship between the Z-Score and the status of the sampled companies. In fact, we confirm a significant negative relationship between the average value of the Z-Score in 2012–2014 and the company’s status. The model confirmed the predictive ability of the Z-Score tool (in its original formulation) to identify the company’s state of evolution. The time horizon, before the appearance of the crisis, extends back to at least two years. All results, however, seem to lose any significance if extended to broader time horizons. Model 2 analysis was born from the need to include in the analysis the Z’-Score in its revised version. Compared to Model 1, the only variables which have been replaced are those related to the Z’-Score. Basically, the non-financial control variables remained unchanged. The results of Model 2 are mostly superimposable, as far as the sign and significance of relationships are concerned, with those in Model 1. The relationship between the company status and the Z’-Score affirms its validity, even in the revised version of the Z-Score. Here again, the relationship on

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time periods exceeding the two years is limited. Yet the model maintains its predictive ability over time horizons limited to two years before the company enters its non-performing period. The standardised beta coefficient appears slightly lower than in Model 1.

8. Empirical Research for the Predictive Ability of Cash Flows for Measuring Firm Performance (2020) As described in a recent study (Ferri, Tron, Fiume, & Della Corte, 2020) summarised later in this book, the main objective of this academic work is to contribute to existing research on the predictive ability of cash flows to forecast future cash flows and performance by providing new evidence from the Italian business context, which is significantly under-explored. In order to fill this gap, we investigate the ability of cash flows to predict future cash flows and, moreover, whether it is able to provide decisive investment information both for the individuals inside the organisations and the subjects outside them. The analysis was carried out on a sample of 168 Italian listed companies in the 2008–2017 period. Similar to earlier researches (e.g., Kim & Kross, 2005; Dechow, Kothari, & Watts, 1998), correlation and multiple regression analyses were used to assess if our cash flow proxies could be strong predictors of future cash flow and thus of business performance. Based on mainstream literature on predictive ability of cash flows, we expected that cash flow components could influence the firm performance (ROA), since, as stated by Tron and Greco (2012), the ability to produce cash is positively correlated with future profitability, and the flows for investments, together with the net cash generation of the company, manage to explain a large part of the variability of the operating income produced in subsequent periods. In this study, the following research hypothesis has been proposed: H1. Return-on-assets (ROA) of year N is influenced by cash flow (CF) N-1. The key variable is the accounting-based proxy for cash flow. The choice of this proxy variable is supported by prior cash flow forecast ability research, as described before.

8.1 Data Source As described in the research, the selection of the sample has objective and replicable criteria: the selected company had to be active and listed on a regulated market in addition to being located in Italy. In doing so, 277 companies have been obtained that met the above requirements. The parameters used for the selection of the companies within the sample were quite rigid with respect to the availability of balance sheet data. For this reason, any company that did not have fundamental data for subsequent analyses for several consecutive years was removed from the sample; this choice was dictated by an excess of subjectivity otherwise required for the reconstruction of the absent values.

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A sample of 176 companies was thus obtained, each with 10 years of consolidated financial statements, from 2008 to 2017. For construction reasons, the first year from which cash flow values can be obtained is 2009; in fact, the first year (2008) was discarded and used only to determine the variations in the stock quantities of the balance sheet and calculate the typical flows of 2009. For dependent and independent variables, the researchers selected an accounting measure as proxy for firm performance which has been widely used in prior Cash Flows (CF) forecasting research: ROA (Return on Assets) 5 Net income/total assets. (e.g., Chen, Cheng, & Hwang, 2005; Firer & Williams, 2003; Shiu, 2006) The indirect method was used for reporting cash flows, starting from the balance sheet and income statement, as reclassified from Amadeus (Bureau van Dijk), the database used for the research. The independent variables relating to the identifiable management areas are the following ones:

• • • • •

Global net cash flow (CF); Cash flow for investments in fixed assets (CFI); Cash flow related to corporate dynamics (CFS); Cash flow from financing (CFF); Cash flow for extraordinary components (CFXC).

8.2 Regression Model The regression analysis consists in a regression equation (model) as shown below: Model: ROA1417i 5 b0 1 b1 CF1013i 1 b2 CFI1013i 1 b3 CFS1013i 1 b4 CFXC1013i 1 b5 CFF1013i 1 «i (i 5 1…176) The model explores the relationship between the cash flows available in the financial statement and the future economic performance of the company.

8.3 Results The results are as follows. Table 4.15 below shows Pearson pairwise correlation results for the dependent and independent variables for an initial exploration of their relationships. Pearson correlations are related to the sample of companies with consolidated financial statements, general analysis, 2010–2013 period vs 2014–2017 period. According to Kennedy (1985), multicollinearity should be considered a serious concern only if the correlation between predictors exceeds 0.8. As shown in Table 4.15, the correlation coefficients between explanatory variables range from a low of 20.6487 to a high of 0.4379. The results indicate that global net cash flow is positively and significantly correlated with the return-on-assets ratio. Cash flow for investments in fixed assets is negatively and significantly correlated with ROA. Cash flow related to corporate dynamics is shown to have a

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Corporate Financial Distress

Table 4.15. Correlation Analysis of Dependent and Independent Variables. ROA1417 CF1013

CFI1013

CFS1013 CFXC1013 CFF1013

ROA1417 1.0000 CF1013 0.4379* 1.0000 CFI1013 20.2121* 1.0000 CFS1013 20.6487* -0.2306* 1.0000 CFXC1013 1.0000 CFF1013 0.2976* 20.5267* 20.3585* 20.2392* 1.0000 Notes: Only the values with a confidence level of 1% are visible; p p , 0.05. Source: Adapted from Ferri et al. (2020).

negative and significant correlation with ROA and a negative and significant correlation with global net cash flow. Noticeably, cash flow for extraordinary components is the only cash flow component that is not significantly correlated with ROA and other cash flow variables. Finally, cash flow from financing shows a positive and significant correlation only with ROA, while with cash flow for investments in fixed assets, cash flow related to corporate dynamics and cash flow for extraordinary components, it has a negative and significant correlation. More details of the study may be found in the published paper (Ferri et al., 2020). With reference to the research hypothesis (H1) it has been found that the sign of the financial management cash flow coefficient remains negative. This could be interpreted as follows:

• •

a cash entry through financing brings a future profitability, if this liquidity is actually invested; eliminating this component, through the use of CFF residues, which exclude the relationship with investments, essentially remains the negative effect of indebtedness, or rather, its onerousness manifested by the interest expense deriving from it.

It is interesting to note that the weight of interest expense not only invalidates future profitability due to the direct contribution to the income statement; this emerges from the fact that the coefficient is significantly different from zero when it impacts on future ROA. Using the data of cash flows from management, we get a very positive review, i.e. the cash flow for investments, the global net cash flow and the flow linked to the dynamics relating to the shareholders, and the net effect of the loans, we obtain a R-square greater than 50% in the estimate of the average ROA of the period 2013–2016.

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Interpreting the signs and values of the coefficients of the regressors, we note that the global net cash flow has a positive influence on future operating income with a beta coefficient 5 0.50, the outgoing flow relating to corporate dynamics has a negative coefficient of 20.93 and to follow we observe a positive impact of the investments (an investment represents an outgoing flow, therefore in order to grasp the economic meaning we must invert the sign of the coefficient); the link exists and is explanatory: in this case, the beta coefficient assumes a value of 20.356. These results are in line with the assumptions of those who claim that cash flows are a better predictor of future cash flows than earnings (Al-Attar & Hussein, 2004; Al Debi’e, 2011; Farshadfar, Ng, & Brimble, 2008; Finger, 1994; Habib, 2010). Al Debi’e results show that the ability of the OCF model is better than that of the Earnings model for all forecast horizons; this predictive ability declines as the forecast horizon increases. It is clear that a large part of future operating income derives from investments made in previous periods and, therefore, it is physiological to see how the investments provide the most informative content on economic performance.

9. Conclusions This review of the main empirical research works on company crises focuses on identifying early warning signals that can be used to immediately define the actions that can be taken with the objective of protecting the company and its value. The goal of saving the company, and its intrinsic value, in the context of ‘physiological’ crisis situations, makes it possible, in most cases, to achieve much better results, both in terms of efficiency and of creditors’ satisfaction, especially if we compare them to those obtained from any agreed-on settlement. It is a widespread opinion, in the economic-corporate doctrine as well as in the legal one, that private negotiation, if promptly activated, is the most suitable answer to corporate crisis, especially if one considers the inefficiency of direct and indirect costs related to all bankruptcy procedures and the final outcome which is seldom favourable to creditors (Paletta & Alimehemeti, 2016). In uncertain economic situations, such as the current one, the ability to predict the phases of financial stress is an urgent and interesting topic for a varied audience of stakeholders, suppliers and moneylenders. Even if there is currently relatively little use, in managerial practice (and also in banking), of adequate predictive indicators, the presented review of empirical research confirms part of the academic theory concerning their ability to predict the state of crisis. The research by the University of Pisa carried out in 2012 and 2013 tried to demonstrate how, in the period examined, positive trends in working capital flow are positively associated to the average ROS, ROA and ROE and to the market value.

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Corporate Financial Distress

The positive trend in the working capital flow expresses, better than any other indicator, the trend in the company’s core business: achieving a good performance in the years preceding the crisis, in fact, allowed the best performing companies to maintain a better profitability during the critical years. The data seem to be confirmed also by the change in net working capital, the excessive expansion of which, against the cash flow from operations, was correlated to low performances in the crisis period. Moreover, the assessment – carried out in 2013 – on cash flows as predictive indicators of future profits, works in the short term. On the contrary, in the long run, earnings and cash flows from operations tend to reveal similar predictive capabilities. The latest research reviewed, carried out by Bocconi and Parthenope Universities in 2018, reaches statistically significant results on a unique business sample (consisting of 232 companies, observed over a ten-year period, from 2007 to 2016). They were selected from their first sign of financial strain, and confirm how much the Z-Score tool succeeds, not only in predicting pathological situations, which are typical of those companies closer to ceasing their activities rather than ongoing-concerns, but also situations of simple financial tension. Financial strain emerges when a company meets difficulties in respecting the terms of payment to the banking community: this was the discriminating and innovative criterion used to create the sample analysed by the research. The instrument proved to be valid in its various configurations (Z-Score and Z’-Score), although this validity has sometimes been criticised in the past. The research had the goal – in accordance with other prestigious literature – to further test the empirical value of the Z-Score as a predictive tool, and it finally attributed even more power to the tool itself. The ability to perceive the initial signs of crisis as early as possible is, in fact, a fundamental theme for its effective solution and for the protection of corporate value (Paletta & Alimehemeti, 2016). As far as the managerial implications are concerned, the results are remarkable. Currently, there is no structured use of the score in the context of banking practice – in estimating the level of risk in the different situations – nor in corporate practice (for example, estimating the level of insolvency risk of customers and suppliers). The results obtained from the research suggest that the signals and methods of prediction should be more widely used, always remembering, however, the limits that all purely qualitative tools present. Prompt recovery processes can, in fact, lead all actors to satisfactory results, both in terms of flexibility, as they are only partially limited by strict procedural rules, and from the perspective of temporal and economic efficiency. The greater efficiency of the tool is related to the possibility to carry out recovery on a going-concern situation. This will preserve, at least in part, the intangible values coming from the organisation and from the company’s activities, which would be lost in the case of failure. The main advantage of promptly activated recovery processes lies in the strategic and industrial values. As soon as crisis is predicted, procedural agreements can be drawn up and, according to the agreement reached with creditors, in

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the way that is considered most convenient, percentages, methods, contents and objectives can be defined. Every recovery plan has to be moulded on the participants’ characteristics and possibilities and on the market conditions in which the company operates. This review provides some points for reflection and may lead to the development of some future research work on key factors which can ensure the success of restructuring activities. With particular reference to the governance variables, a generic first conclusion, emerging from the results of the various research studies recently carried out, is a greater injection of new ideas, achieved by a higher turnover rate in the management of companies (Board of Directors: how long do their terms last? how often does the Chairman change?) leads to a lower probability of crisis, no matter how serious. All this confirms the initial hypothesis, i.e. the importance of early prediction of crisis and its early management to preserve company value. The topic is of extraordinary relevance, and although there are only a few studies on it, it deserves further academic research and analysis.

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Chapter 5

Business Case: The Financial Restructuring of the ‘Alpha’ Group (2013–2015)* 1. The ‘Alpha’ Group and Its Business Model Over Time The Alpha Group (from now on ‘Alpha’ or ‘Group’) has been operating for about 50 years in the production and marketing of articles for schools and leisure time (in particular, accessories and paper products). With a production value that reached about 45 million euros in 2013, it has a leading position in the market segment of school accessories for primary and middle schools, for children aged between 8 and 14. The Group’s history is characterised by the entrepreneurial intuition to include sports accessories for the school channel, which previously had never been considered a profitable market. In a few years, the Group has grown from 50,000 to 600,000 units produced, with the continuous doubling of turnover year after year. This intuition essentially gave rise to a new market where the Group immediately played the role of leader and still dominates today. Growth was sustained first by the outsourcing of some production phases to small Italian workshops and then by the relocation of production to Eastern Europe and China. The decision to locate production first in Romania and then in China was aimed at reducing labour costs (which represented 30% of the industrial cost), protecting product margins and achieving a more competitive selling price policy. The phases considered as strategic, such as the procurement of raw materials, quality control (based on the features internally defined by the brand and the product managers when designing the collections) and the coordination of production, entrusted to ‘satellite’ suppliers closely linked to the company, are carried out by one of the Group companies, based in Hong Kong.

Note: This business case deals with the strategic and financial restructuring of an industrial group manufacturing products for schools and leisure. To preserve confidentiality, the name of the holding company has been changed to ‘Alpha’ and the name of its main subsidiary to ‘Beta’. With the same aim, the competitors have been given artificial names such as ‘Gamma’, ‘Delta’, ‘Theta’, etc..

*

Corporate Financial Distress, 101–137 Copyright © 2021 by Emerald Publishing Limited All rights of reproduction in any form reserved doi:10.1108/978-1-83982-980-220211006

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The direct presence in the procurement and production market, a distinctive and characteristic element of the Group, has made it possible to safeguard the high quality of the products. Since its origins, as its business model the Group has chosen to develop the collections with its own brands and to consider licensing as a complement to its offer in order not to miss out on any of the levers of the marketing mix (product, price, promotion and distribution). One of the most important steps in the Group’s history is the acquisition of the long-running and successful competitor brand ‘Beta’. Thanks to this operation, which was made possible by the excellent results achieved by the Group in the 1990s and early 2000s, in 2006 the Alpha Group became the leading operator in its market, thus strategically influencing the development of what would be the future competitive reference scenario. The main elements that characterise the Group positioning as market leader are the following:

• • •

the ownership of two relevant brands, historically present in the market and enjoying an excellent positioning; the transversal presence in all the three main reference targets of which this market is composed; the presence in all the main distribution channels and particularly in the retail channel, thanks to a selected network of over 3,000 selling points, both in the large-scale retail sector with historical and consolidated relationships with all the main chains, as well as through a network of wholesalers and dealers; furthermore, the Group is present on the Internet through its e-commerce channel on its own portal, dedicated to online sales.

Thanks to its expertise in product development and the reputation of its own brands, the Group now has a wide range of collections for every type of use, target audience and price range. One of the main features of Alpha’s product offering is its recognised leadership in the quality of materials, innovation and functionality. The direct presence – for over 20 years – with its own organisation in the producing countries guarantees a production quality identical to that of the 100% Made in Italy variety.

2. The Reference Market and Sector The Group’s reference market is the production and marketing of products for schools and leisure time, particularly satchels, accessories (representing the ‘sewing’ segment) and paper products. The market is characterised by being a small entity (in 2011, the total value amounted to 371 million euros) and a mature market, due to the negative growth rates in recent years, driven by a sharp drop in demand (in terms of volumes) and a slight rise in prices. The decline in consumption is also due to consumers’ different approach to the purchasing process (i.e. favouring cheaper products). The market focuses on

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purchases of high-quality products that come with a relatively high price, and a low purchase frequency. In the two-year period (2009–2011), the satchels and accessories segment, which is the Group’s core business, registered a negative growth rate of 2.7% (CAGR 09–11), while the paper-making segment had a negative growth rate of 1.5% (CAGR 09–11), as shown in Fig. 5.1. A concise and meaningful reading of the market can be made by examining two main drivers that influence, inter alia, the strategic and successful choices of operators:

• •

the distribution channel: the main traditional distribution channels for the Group’s products are essentially identified in the retail network (mainly consisting of stationers) and in the large-scale retailers; the reference target: three main reference targets can be identified and, in particular: (1) under 8 years; (2) aged between 8 and 14 years; (3) over 14 years. The target thus identified may be further segmented to consider the different reasons for purchasing as shown in Table 5.1.

The Alpha Group satisfies each target with different brands and different business units, each with its own competitive logic. In terms of value and weight as a percentage of the total market, the Group’s reference segment, identified in accessories for the 8–14 age group, in which Alpha is the leader, reached a total value of €79 million in 2011 (before the Group’s financial crisis in 2012), equal to approximately 22% of the market. For the following years, negative growth rates were estimated: the total estimated value in 2015 was around 344 million euros compared to the 371 million in 2011 and to the 410 million in 2007. A sharp contraction in turnover was expected, especially in the retail channel (paper products shops), due to both a significant reduction in consumption and in the number of stationers in the area (Figs. 5.2–5.3). 450 400 72

CAGR % 07-09

69

350

66

CAGR % 09-11

-2,90%

-2,00%

-1,90%

-2,70% Accessories

-3,80%

-1,50% Papermaking

-1,80%

-2,70% Backpack

300 250

216

199

200

194

150 100 50

122

118

111

2007

2009

2011

0

Backpack

Papermaking

Fig. 5.1.

Accessories

2007–2011: Market Trend by Product.

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Table 5.1. Customer Segments. Age Target

Purchase Logic

Decision-maker

6–8 years

Similar to toys Importance of cartoon

8–14 years

More sophisticated purchase Attention to the price by the parents but the choice is entrusted to the child Choice of a product for not only school use Total autonomy in the choice by the child

.14 years

50% Child 37% Family 13% Mother 75% Child 10% Family 15% Mother 100% Child

Market trend broken down by distribution channel 450 400 350 300 250

304

294

284

273

263

256

253

83

85

87

88

89

90

91

2009

2010

2011

2012

2013

2014

2015

200 150 100 50 0

GDO

Fig. 5.2.

Stationers

Market Dimensions.

Market trend broken down by distribution channel - 2,3 CAGR + 1,3 CAGR 2009

2010

2011

2012 GDO

Fig. 5.3.

2013

2014

Stationers

Market Dimensions.

2015

The Financial Restructuring of the ‘Alpha’ Group

105

The Alpha Group was able to oppose this trend thanks to its better positioning on both distribution channels if compared to its competitors. The competitive scenario, in 2011, was characterised by the presence of a clear leader for each reference target: (1) Gamma with reference to the under 8 segments; (2) Alpha in the 8–14 segment; and (3) Omega in the over 14 segments. With regard to competitors, the sector maturity, combined with the drop in sales volumes, was penalising all the main market operators. In particular, it should be noted that rival firm Theta was performing badly (24%, and 218 million euros in sales), as it was in crisis conditions, releasing free market shares that in 2011 were worth about 40 million euros in sales, in the ‘sewing’ segment alone (satchels and accessories). The market share of the first 5 years went down by 2 9% between 2009 and 2011, after a growth of 17% between 2007 and 2009. The key distinctive factors of the Alpha Group 2 when compared to its main competitors 2 may be summarised as follows:

• • • • •

it stands out for innovation, quality, aesthetics, design and tradition. The Group has always been appreciated for its ability to innovate products coherently with the changing needs of consumers. A lot of these innovations have also been protected by international patents; the Group’s offer is wide (it includes a lot of references) and transversal (it satisfies different targets and different use opportunities); the Group has a leadership position in terms of national geographical coverage; abroad it suffers from a significantly different price positioning and product perception if compared to Italy; growth continued for over a decade, allowing it in 1998 to exceed the market quantities produced by Beta, which was a market leader at the time (Beta was acquired by Alpha in 2006); the development of new brands to reach the different reference targets more effectively.

3. Causes of the Alpha Group Crisis The unfulfilled expectations of a continuous growth in the school accessories market, the significant investments (in securities and real estate) in recent years with the acquisition of the Beta brand (and of a new headquarters and logistics site) together with the changes in the business model (the way the Company had to buy and sell products), contributed to the financial tension which affected the whole Group in 2012. To reach a full awareness of the reasons which led to the financial, equity and, partly, economic crisis, with inevitable impacts on the Group’s financial structure and flows, the causes of the crisis have been divided into exogenous and endogenous causes.

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Corporate Financial Distress

3.1 Exogenous Causes With reference to the external environment, the main exogenous cause of the Group’s crisis was the global economic crisis which affected every economic sector from 2008, causing, among other issues, a sharp reduction in consumption, also with regard to the goods produced and marketed by the Group. In particular, the Group had a history of constant growth that became exponential at the turn of the 2000s. On the basis of these results, the management designed and implemented a strategy of further growth, assuming an ideal size in relation to the expectations that the reference market made it possible to estimate for the following years. Fig. 5.4 shows the evolution of Alpha’s invoicing volumes in the decade between 1994 and 2003: it shows the growth of the Company to about 60 million euros, recording a 1400% increase compared to the beginning of the period. From 2008 onwards, expectations of continuous growth were not met, not only in the school accessories market but also globally in every sector of the economy, with few exceptions. In such an overall economic scenario – where lots of markets shrank almost to the point of disappearing – the Group maintained an excellent positioning and leadership in its sector, with its two main brands, Alpha and Beta. More specifically, the effect of the global economic crisis led to a significant contraction in consumption, mainly evident in a reduction in the purchase frequency of its products. In particular, there was a lengthening of the average life of a product and a reduction in the replacement rate which resulted in an overall contraction in volumes. This downward trend in volumes was, in part, offset by a possible and sustainable increase in the average price of products. This aspect – which might not necessarily appear positive in terms of future pricing strategy and policy – has to be read carefully for the Alpha Group. In fact, by pursuing a precise commercial strategy, the Group gradually reduced its share of volumes linked to licensed products by significantly increasing the sale of its own branded products, thus featuring a higher average price. This aspect means that the maintenance of a

60.000 +420% 50.000 40.000 30.000

Production Value (Sales)

20.000 10.000 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

Fig. 5.4.

Trend in Production Value.

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107

significant turnover, despite the decrease in volumes, was not the result of a choice Alpha imposed on the final consumer, but of a careful and deliberate strategy that led the consumer to choose a product with a higher average price. In this scenario, in fact, a key strength and success factor which allowed the Group to maintain its competitive position and leadership was the recognised quality of its products.

3.2 Endogenous Causes The endogenous causes of the crisis are essentially to be found both in the company’s choices, which proved to be inadequate before the unpredictable events related to the changed economic scenarios, and, above all, the lack of any timeliness in implementing the necessary recovery actions. Here are the main identified endogenous causes explained in detail:

•

•

acquisition of the Beta company and brand: this operation, which took place in 2006, required a total financial commitment of about 20 million euros, largely financed by the banking system (about 15 million euros) and to a lesser extent by Alpha’s own financial resources. The operation was necessary both from a commercial and strategic point of view to protect Alpha’s competitive positioning and maintain its leadership position. At the time of the acquisition, Beta had a turnover of around 30 million euros, 50% of which came from the clothing and accessories segment, 27% from the school sector, 12% from snow gloves alone and 11% from briefcases and bags for mountain excursions and leisure. In the years that followed, Beta’s volumes were significantly reduced, the crisis in the clothing sector had led to a consumption shift towards cheaper products, while the weather conditions caused a drastic drop in sales of winter sports products. The combination of these negative events led the company, in a short time, to results that differed significantly from estimated ones, making the structure inefficient and draining finance from the Group’s coffers as the disbursements to repay the loans for the purchase amounted to 15 million euros; investment for the new headquarters: in the wake of the results recorded by the Group in the early 2000s and, on the basis of growth expectations, the management positively evaluated the opportunity to have a single logistics site and therefore, in 2003, built a new headquarters which was completed in 2006. The total financial commitment was approximately 30 million euros, considering the leasing and the additional amounts with an impact – in terms of financial outlay – of approximately 2.2/2.5 million euros for the payment of leasing instalments alone. However, due to the poor performance in terms of market growth and turnover, negative effects, with reference to the investment in question, resulted both in financial terms (due to the disbursement of a significant leasing instalment as well as to the worsening of the indices against a net financial position – hereinafter also referred to as NFP – that was substantially imbalanced and not offset by any adequate economic results), and in economic terms, due to higher operating costs. The Group, moreover, faced an

108

•

•

Corporate Financial Distress

objective oversizing: the surface area per capita, for instance, was three times greater than the average recorded in the same industrial sector and among competitors; excessive oversizing of the structure, which resulted in inefficiencies and extra costs: the excessive oversizing of the structure became unsustainable in a profoundly changed market context which instead required a lean structure, with adequate skills and costs aligned to market conditions. The management, before the recovery actions contained in the 2013–2015 Plan, had launched some cost reduction actions, although the excessive length of the intervention times only led to incremental margin losses; changes in the business model with consequences in terms of supplier payments and collections from customers and a direct effect on the financial requirements related to the working capital: the changes in the business model concerned the procurement and distribution strategy.

The procurement strategy resulted in the relocation of production of stitched items to low labour-cost countries a and this led to an increased need for working capital for two main reasons: (1) the need to plan a production launch for Italy/ Europe 120 days in advance due to the logistics of transporting from China; (2) the change in payment terms, from 120 days from invoice date for the Italian suppliers to 30 days from delivery of goods from Far East suppliers. The second change concerned distribution with the decision to serve the retail channel directly rather than indirectly through dealers/wholesalers. This led to a significant increase in the number of components in the Group customer portfolio: from about 50 dealers, to over 3,000 outlets. This change provoked a consequent lengthening of the financial cycle, causing the extension of average collection times and a greater complexity in credit management:

•

reduction in credit lines: the cause of the financial crisis was, ultimately, the significant reduction in short-term credit lines that occurred in 2012 for about 7 million euros. This reduction, due to the infra-annual dynamics of the Group financial requirements, led to an incremental need for liquidity during the year.

It should be noted that the causes of the crisis as described above occurred in a situation in which the Group, thanks to some actions taken by management (cost saving measures), tried, in the three-year period (2010–2012), to contain the margin erosion, as shown in Figs. 5.5–5.6. From the financial point of view, net of the requirements deriving from the infra-annual dynamics, a decreasing trend in the ratio between NFP and EQUITY and between NFP and EBITDA may be observed already in the threeyear period (2010–2012) (Fig. 5.7). In any case, the actions implemented by the management were not sufficiently strong to achieve an economic, financial and structural balance. For this reason, the management, with the help of one of the leading international strategic consulting firms and of a pool of professionals, defined a recovery strategy for the

The Financial Restructuring of the ‘Alpha’ Group

109

Ebitda margin evolution 2010-2012 (000/€) 59.200 49.200 39.200

50.641

50.215

14%

12%

47.444

12%

12% 10%

9%

8%

29.200

6%

19.200 9.200

4% 5.991

4.689

5.638

2% 0%

-800 2010

2011 Sales

Fig. 5.5.

EBITDA

2012

Gross Profit

Ebitda margin %

EBITDA Margin Evolution 2010–2012.

Cost saving 2010-2012 Salaries Wages

Selling expenses

Variable purchase costs 0

5.000 2012

Fig. 5.6.

10.000 2011

15.000

20.000

2010

Cost Savings 2010–2012.

three-year period (2013–2015), affecting three main interconnected dimensions: competitive repositioning, organisational restructuring and redefinition of the financial structure.

4. Recovery Actions: The 2013–2015 Financial and Strategic Recovery Plan Due to the persistence of the unfavourable economic situation and to the critical issues that emerged within the Group, in 2012 (as part of the broader process of recovery of all the Group companies), the management deemed it appropriate to undertake a corporate restructuring process to restore profitability and financial

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Corporate Financial Distress

NFP/Ebitda - NFP/NE (2010/2012) NFP/EQ

NFP/EBITDA

14,0 12,0

12,3

10,0

8,7

8,6

6,6

6,1

5,9

8,0 6,0 4,0 2,0 0,0

2010

2011

2012

NFP/EQ

6,6

6,1

5,9

NFP/EBITDA

12,3

8,7

8,6

Fig. 5.7.

NFP/EBITDA, NFP/NE (2010–2012).

equilibrium. The process was completed in June 2013 through the positive assessment/audit by an independent professional, of the 2013–2015 Recovery Plan (hereinafter also referred to as the 2013–2015 Plan), drawn up pursuant to art. 67, paragraph three, letter d), R.D. no. 267 dated 16 March 1942 (Fig. 5.8). The 2013–2015 Plan, developed with the main objective of restoring the Group’s financial, economic and equity balance over the reference period, was based on the following strategic guidelines:

•

•

revision of Beta’s business model (revenues generated only by ‘pure’ licensing exclusively to the parent company Alpha). With the restructuring of the Group’s organisational structure (which led to the divestment and closure of companies that were no longer performing) and the desire to concentrate resources and energy on the core business, the 2013–2015 Plan strategically redefined the business model of the Beta brand. Beta became the brand licensor (for the production of accessories and, in the future, clothing) which exclusively received the income from royalties from the sales of Beta-branded products. Such an important action also made it possible to achieve a structural streamlining and an optimisation of general and staff costs. As can be seen from Fig. 5.9, in fact, such action led to a significant generation of cash flows for Beta and made it possible to archive the negative results for the benefit of a business model which was maybe defensive but certainly a source of income and cash generation. real estate divestments (‘X’ project: contract release of the leasing on the logistics area and overturn/cost sharing). The combination of the economic and financial effects linked to the failure to meet market growth expectations and logistical needs led to the evaluation of the disposal of the real estate complex (logistical hub) while seeking to avoid the depletion of the company’s assets by selling it, considering the serious crisis affecting the real estate sector.

Business Recovery Plan

«Beta» company and brand acquisition

Redefinition of the business model

Action Plan

Strategic Target

Positive economic result Positive cash flows production Reduction of the NFP

Real Estate new investments

Transfer of the logistics area

Reduction of the establisment costs Financial charges reduction Active contingency collection price

Organisational oversize Staff salaries

Over-sizing of overhead costs

Reorganization of the staff structure

Benchmark redction staff costs (8-9%)

Overhead cots optimisation

Overheads reduction and optimisation

Economic and financial balance

(considering the works to be done in the registered office)

Increase in working capital

Fig. 5.8.

Ridefinition of the cash in and pay out conditions

NWC optimisation

Causes of the Crisis, Recovery Actions, Operational Objectives, Strategic Objectives.

The Financial Restructuring of the ‘Alpha’ Group

Causes of the crisis

111

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Corporate Financial Distress

Sales Othes sales (royalties) Total sales COGS Gross Mrgin Cost of sales Gross Profit - I Other costs Gross Profit - II Expenses and losses Ebitda Accruals and amortization Ebit

Fig. 5.9.

-

2010 2.232 1.677 3.909 1.661 2.248 225 2.023 400 1.623 1.008 615 1.720 1.105

-

2011 1.327 1.687 3.014 839 2.175 110 2.065 987 1.078 941 137 801 664

-

2012 1.184 1.194 2.378 1.056 1.322 51 1.271 267 1.004 658 346 661 315

2013 P 860 1.040 1.900 860 1.040 1.040 1.040 86 954 490 464

-

2014 P 1.220 1.220

2015 P 1.290 1.290

1.220 1.220 1.220 86 1.134 470 664

1.290 1.290 1.290 86 1.204 350 854

-

CAGR

-9% -7% -4% 12% -177%

Effects of Recovery Actions on Beta’s Performance.

The operation was necessary for a double series of reasons: on the one hand, the reduction of management costs and structural charges related to the property, and, on the other hand, the need, for the success of the proposed financial intervention to improve the net financial position and support recovery. In 2013, the Group reached an agreement to sell part of the property complex to a logistics partner of the Group. This agreement made it possible to heal one of the causes of the crisis and obtain economic and financial benefits:

• • • • • • •

a reduction of the net financial debt by about 15.6 million euros, or more than 30%; the reduction in structural costs related to the property management versus the general costs related to the logistics area; the reduction in financial costs due to the release of a substantial portion of the real estate leasing; the reduction in other general costs related to the property (taxes); the contingent assets resulting from the realisation of a greater economic benefit taking into account all the necessary adjustments at a consolidated level; the collection of the difference between the agreed price (15.6 million euros) and the takeover value of the leasing (14.3 million euros); Streamlining of the organisational structure and optimisation of staff costs. The Group’s management identified the oversizing of the organisational structure as one of the causes of the crisis and deemed it appropriate to revise it – while maintaining the business model: they considered the changed economic scenario, their needs in terms of staff requirements and also their ability to absorb this cost. So the management decided to implement a specific action plan as a part of the Business Recovery Plan. This was a recovery action that would have led to a further reduction in staff costs of approximately 1 million euros, if compared to the 2012 situation. The guidelines focused on the need to rationalise all management roles and dismiss all redundant resources that had been promptly identified. Furthermore, an overall review of wages was carried out in order to align them with the market benchmarks (8–9%);

The Financial Restructuring of the ‘Alpha’ Group

• •

•

•

113

reduction of executives’ salaries: from 2013, the owners themselves contributed to overcoming the crisis. In fact, the fees of the Board were reduced by 67%, with a benefit, in economic terms, of about 700 thousand euros per year; reduction in general costs. The 2013–2015 Plan also acted on the structure of overheads, indirectly, through a wider reorganisation of the subsidiary Beta, and directly, through a wider rationalisation of costs, the renegotiation of supply contracts and the identification of corporate spending policies. This intervention would have led to a reduction of approximately 600 thousand euros (400.000 of which in 2013 and 100.000 in 2014 and 2015, respectively); optimisation of working capital: redefinition of supplier payment terms and of collection terms from customers. In order to reduce the amplitude of the financial cycle and working capital requirements, payment terms were renegotiated with some suppliers, in particular those from the Far East. The management renegotiated – with all suppliers (for a total value of about 10 million euros) – the payment terms: from the 30 days after delivery of goods (at container closure) which starts with a letter of credit paid in advance – to the current 30/60 days after shipment. The second useful intervention, to reduce the need for working capital, was to redefine the collection conditions with the retail channel by concentrating the deadlines linked to sales for the school campaign in only two instalments. For more than 3,000 retail outlets (for a value of approximately 15 million euros), the previous due dates in September, October, November and December were concentrated in September (approximately 70%) and October (the remaining 30%); development of appropriate commercial strategies aimed at consolidating the leadership in the ‘back to school’ sector and entering market segments and niches close to the core business. These are the main objectives that the Group intended to achieve in the three-year period (2013–2015): continuation of the development strategy based on its own brands; completion of direct coverage of retail distribution; consolidation of Beta’s target in the over 14-year-old segment through a reversible backpack distributed to the large-scale retail trade; new leisure and office product projects; diversification of distribution channels through the entry into the leather goods channel; possible expansion of the Group’s reference market share, which could be left free of competitors.

In addition to these factors, it must be considered that in 2012 there were no elements which suggested any significantly different future scenarios from those assumed in the Business Recovery Plan, which showed hypotheses of revenues, in the three-year period (2013–2015), between 45.5 and 47.5 million euros. Again, in relation to the expected revenues, it should be noted that the 2013–2015 Plan did not incorporate the actual potential of the commercial and sales scenario planned by the company and, therefore, it was built on the basis of a completely conservative vision, the viability of which had been assessed by stress tests as well. In the event of any further reductions in revenues, the Group could have applied a contingency plan, i.e. an extraordinary cost reduction on structure and staff (without any risk for strategic functions and skills), thus recovering any margin loss.

114

Corporate Financial Distress

Fig. 5.10 shows a summary of the effects of the Group’s recovery strategy on its main business performances.

5. The Proposal of a Financial Intervention To support the implementation of the 2013–2015 Recovery Plan, in June 2013, a Banking Agreement was signed between the Group companies and the banking community (Table 5.2; Fig. 5.11). The objectives of the intervention on the banking system were the following:

• • •

overcoming the contingent situation of financial tension by consolidating part of the short-term debt and rescheduling the medium-term debt; revisiting the model and structure of short-term credit lines to adapt them to the needs of the banking class and of the company reality; achieving a structural financial balance.

It should be noted that the financial intervention originated from the strategic and fundamental ‘de-leveraging’ operation on the logistic site: this concerned the leasing and management of the logistics centre with a binding purchase option (partial takeover of the real estate lease for the portion of the warehouse) for a total value of 15.6 million euros. This transaction, in fact, contributed substantially to the significant reduction in the net financial position, at the end of the three-year period, for a total of 20 million euros (16 of which from the sale of the real estate leasing contract related to the logistics area). The Agreement was characterised by four elements:

KPI

2012

2015 P

sales

€M 47,4

+ 0,1 €M

€M 47,5

GROSS MARGIN %

32%

- 0,91 %

31,09%

EBITDA %

11,9%

+ 3,3 %

15,2%

EBIT %

5,1%

+ 6,2 %

11,3%

NFP

€M 46,8

- 19,5 €M

€M 27,3

Fig. 5.10.

KPI 2012–2015.

The Financial Restructuring of the ‘Alpha’ Group

115

Table 5.2. Details of Consolidations by Company and Credit Institutions. Bank

Alpha

Beta

Total

Boundaries consolidation Bank ‘A’ Bank ‘B’ Bank ‘C’ Bank ‘D’ Bank ‘E’ Bank ‘F ’ Consolidation of non-operating bank, s Bank ‘G’ Bank ‘H’ Bank ‘I’ Bank ‘L’ Bank ‘M’ Boundaries consolidation Beta Bank ‘A’ Bank ‘B’ Bank ‘C Financial charges consolidation Oneri finanziari TOTAL GROUP

6.488 2.847 1.500 917 315 632 277 2.797

-

-

6.488 2.847 1.500 917 315 632 277 2.797

2.156 834 208 1.114 180 180 2.336

732 842 626 438 159 2.156 834 208 1.114 l.150 1.150 12.591

732 842 626 438 159 -

970 970 10.255

(1) the provision of two categories of banking institutions: the operational banks (i.e. banks that participated in the financial intervention and maintained the credit lines) and non-operational banks (that expressed their unwillingness to maintain the short-term lines with the consequent sharing of return plans); (2) a financial intervention articulated in three macro areas of interventions: (i) consolidation of overruns and interest expenses amounting to 12.6 million euros. The Agreement forecast the repayment over six years, starting on 1 January 2015 (with a period of 18 months of pre-amortisation); (ii) rescheduling of payables for medium/long-term loans for a residual capital amount of 4.3 million euros. The new amortisation plan provided for repayment over 6 years with the first due instalment on 31 March 2015 and the last on 30 October 2020; (iii) immediate repayment (at the start of the financial intervention) of the non-performing lines for a total value of 8.5 million euros. This

116

Corporate Financial Distress

Boundaries consolidation Consolidation of non-operating bank credit lines

9%

Boundaries consolidation Beta Financial charges consolidation

17%

52%

22%

Fig. 5.11.

Details of Consolidations by Company and Credit Institutions.

repayment was considered necessary by the institutions, to release the lines from overdue and problematic loans in such a way as to make them fully operational (Table 5.3). While defining the repayment plans, the structure of short-term credit lines was also revised, within the Agreement, in line with the banks’ need to reduce the credit lines and with the Group’s needs arising from the Recovery Plan. In particular, within the financial intervention, the credit lines were determined based on the following assumptions:

• • •

the expected economic performance, in view of the recovery measures adopted in the Plan; the Group’s ability to produce cash and, in particular, Beta S.p.A.’s autonomous financial capacity after the reorganisation and modification of its business model; the change in payment and collection conditions after the interventions on the working capital structure.

Credit lines were reduced to three types, in addition to cash, as shown in Table 5.4: (1) credit advances – subject to collection (in particular bank receipts) intended to meet the need to sell off the turnover from the retail channel, necessary to grant liquidity and make payments to Chinese suppliers in the second quarter of the year. The granted lines amounted to a total of 5.3 million euros; (2) lines for import and Italian supplier financing: these credits allow for the payment of Far East suppliers (concentrated in the period April–November)

The Financial Restructuring of the ‘Alpha’ Group

117

Table 5.3. Past Due Items. Bank

NPL

Bank ‘A’ Bank ‘B’ Bank ‘C’ Bank ‘D’ Bank ‘E’ Bank ‘F’ Total

2.450 4.800 520 360 100 260 8.490

Table 5.4. Credit Lines. Bank

Bank ‘A’ Bank ‘B’ Bank ‘N’ Bank ‘C’ Bank ‘D’ Bank ‘E’ Bank ‘F ’ Bank ‘O’ Total

Cash Credit Line Factor Invoices Advances Import advances Total

2.000 1.000 50 400 250 500 150 4.350

7.000 7.000

1.825 1.500 300 516 500 500 150

2.450 3.500

5.291

6.400

170 280

6.275 6.000 350 916 920 1.000 580 7.000 23.041

and of Italian suppliers for the paper-making sector (concentrated in the period November–February). The granted lines amounted to a total of 6.4 million euros; (3) credit disposal lines through ‘notification’ and ‘captive’ factors for the disposal of the turnover from the large-scale retail trade and wholesalers falling due in the last months of the year. These lines are used to meet the financial requirements of the second half of the year. The granted lines amount to a total of 7 million euros for the ‘notification’ factor, while for the ‘captive’ factor, lines are granted for the entire need (this is the disposal of the turnover to the main brands of the large-scale retail trade that rely on the respective factoring companies).

118

Corporate Financial Distress

The financial intervention had a dual aim: to bring debt to a sustainable level and to meet the financial needs of working capital, as highlighted in the 2013–2015 Plan in an impartial manner.

6. A Successful Turnaround: Overcoming the Financial Crisis Situation of the Alpha Group The Group’s economic and financial difficulties, which appeared in 2012 as an inadequacy of prospective cash flows to meet planned obligations on a regular basis and which could have ended in a possible state of insolvency without any effective and timely intervention, started a change process that made it possible not only to remove the causes of dysfunctionality within the Group but also to increase corporate value and formulate new conditions for success. In the three-year period (2013–2015), the Group realised all the actions forecast in the Recovery Plan and achieved (sometimes even exceeded) all the commercial, economic, financial and equity objectives. In commercial terms, the Group’s positioning on the market in the three-year period (2013–2015) improved: its leadership was reinforced and consolidated by a significant increase in market share, both in retail and in large retailer channels. The distinctive and unique features of its business model – brand, quality and product innovation – enabled the Group to consolidate and strengthen its leadership in a shrinking and highly evolving market. The further strengthening of its own brands (3/4 of turnover in 2015) helped to emphasise its truly distinctive character and was a critical success factor. In 2015, the Group achieved a market share of 19% in the retail channel and of 30.9% in the large-scale retail channel. On the large-scale retail channel, the Group market share referring to its core business was 40.5%, 25% points more than the second competitor, which stood at 15.6%. The 2016–2018 Business Plan provided for a further improvement in the results achieved and did not present, as we will see in detail in the following paragraphs, any elements or situations that could have jeopardised the overcoming of the crisis. Considering the achieved results, the objective restructuring and structural (current and perspective) economic and financial recovery and rebalancing, the Group and the main credit institutions together decided to resolve the Banking Agreement.

7. The Achievement of the Commercial, Economic, Equity and Financial Objectives of the Recovery Plan during the Turnaround Period In the three-year period (2013–2015), the Group implemented all the actions of the Recovery Plan, aimed at overcoming its temporary financial tensions and restoring a typical economic, equity and financial balance of a company in normal operating conditions. It is important to remember that the crisis situation was not of an industrial nature, but only financial. In fact, the market always welcomed the Group’s products, recognising the strong value of the brand and its distinctive

The Financial Restructuring of the ‘Alpha’ Group

119

Table 5.5. Recovery Actions and Objectives Achieved. CA USES OF THE CRISIS

"ALPHA" BUSINESS MODEL

ACTION PL AN Business model form distributor to licensor full closure of employment rel at i onshi ps

OPERA TIONAL TARGET

OBJECTIVE ACHIEVEMENT

Net profit P osi t i ve c ash flows

Cost optimisation/outsourcing

INVESTMENTS

STAFF

OVERSIZING OF THE ORGANISATIONAL STRUCTURE

WORKING CAPITAL

Transfer of operating area leasing Overturni ng and shari ng c osts

Redefinition of the organisational structure St aff c ost opti mi zati on Ski l l s needs assessment Redundancy mnagement

Overturnig to Leaser Cost reduc t i on: c onsul t anc y, insurance, credit services, staff charges vehicle costs, taxes

Payment terms changes to suppliers (DPO) Changes i n t erms of c ol l ec ti on from retail customers

NFP Optimisation Establishment of cost reduction Fi nanc i al charges reduc tion Contingent assets form dispossal

Coverage of needs skills Reduc ti on of st aff c ost t o t he benc hmark (8 -9 %)

Overhead c ut-off and optimisation

Reduc ti on of working capital requirements

features of quality and technological innovation. The 2013–2015 Plan responded primarily to the need to restore a financial and equity balance (Table 5.5). The apparent failure to achieve the objective concerning the organisational structure and staff costs, which had to be kept at 8–9% of the production value (considered a market benchmark), as can be seen in Fig. 5.12, is justified by the higher volumes recorded in the three-year period, which required a higher number of people than that envisaged in the Recovery Plan. However, although the number of people in service in 2015 was 8 units higher than those expected in the Plan, they were anyhow still fewer if compared to the 2012 situation. Moreover, it should be noted that the main objective set out in the Recovery Plan, namely, to reduce the incidence of the staff costs within the benchmark parameter, was fully achieved in 2015 (Fig. 5.13). In the recovery process, the transformation of Beta’s business model, changing from a production and distribution company to a brand licensor for the various product categories, represented a fundamental element, allowing for an important repositioning of the brand on the market. Not only the clothing sector but also the satchels and boxes sector was involved. For the latter, the strategic action was to target the ‘over 14s’. The success of the action taken on the business model can be seen from the trend in revenues from Beta brand products represented in Fig. 5.14.

120

Corporate Financial Distress Staff - evolution 2013-2015

92

N.RISORSE

Staff 2012

RBP

Real

RBP

2013

Fig. 5.12.

Real

RBP

2014

Forecast 2015

Staff 2013–2015 (Recovery Business Plan vs Real). Salaries and Wages - Impact of staff costs

10%

10,30%

10%

4.722

8,4%

4.700

4.682

8,6%

9,6%

9,20%

4.637

4.610 4.300 4.000

RBP 2012

Real 2013

Fig. 5.13.

RBP

Real 2014

RBP

Real 2015

Personnel Cost Impact 2013–2015 Recovery Business Plan vs Real.

Overall, therefore, the Beta brand generated revenues, in 2015, of approximately 24 million euros (equal to 45% of total production value). To reach the Banking Agreement, another aspect of considerable importance, in addition to the objectives set out in the Plan and fully achieved, was the entry of a new institution among the operating banks which granted credit lines and loans for an amount of 7 million euros, 4.5 of which were in the medium term. The entry of the new bank allowed the immediate end of all relationships with the non-operating banks, and a partial early repayment of the medium-term loans to the operating banks. The operation also made it possible to simplify and opportunely remodel all relations with the banking system, especially with the three main banks having similar shares and representing 80% of the overall financial debt and with the other four banks exposed with medium-sized loans.

The Financial Restructuring of the ‘Alpha’ Group

121

revenues evolution Beta 2013-2015 45%

18.000 16.000 14.000 12.000 10.000 8.000 6.000 4.000 2.000

50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 0%

31% 18%

-

2013

2014

School accessories

Clothing

2015 impact on the value of Group produc on

School accessories Clothing

2013 7.908 0

2014 12.158 2.554

2015 15.346 9.000

impact on the value of Group production

18%

31%

45%

Fig. 5.14.

Turnover Trend Beta 2013–2015

8. The Group’s Performance in the Recovery Phase (2013–2015) With regard to the quantitative performance, the three-year period (2013–2015) of the Recovery Plan saw the Alpha Group achieving all its economic, financial and equity targets. Revenues grew steadily, reaching over 54 million euros in 2015; this corresponded to a growth of almost 20%, compared to 2012, and was higher than the revenues estimated in the planning phase, as can be seen from Fig. 5.15. In the three-year period, sales figures showed a constant growth trend both year to year (YtY) and with respect to the Plan. Overall revenues were 4.3% higher than

Net revenues - Recovery Business Plan vs Real

47,444

2012

45,520

45,000

46,520

48,100

47,529

54,182

RBP

Real

RBP

Real

RBP

Real

2013

Fig. 5.15.

2014

2015

Net Revenues 2013–2015 Plan vs Real.

122

Corporate Financial Distress

expected; compared to a 1% lower result in 2013, the following years – 2014 and 2015 – recorded positive changes, respectively by 3.4% and 14%. On the other hand, the changes with respect to the previous year (YtY) of the actual data show very significant growth rates. With the exception of 2013, still affected by the internal and external crisis situation, 2014 and 2015 recorded growth rates of almost 7% and over 12%, respectively (Fig. 5.16). The margins recorded in the three-year period were significantly higher than those envisaged in the 2013–2015 Recovery Plan, both in absolute terms, due to the increase in revenues, and in percentage terms (Fig. 5.17). The actions implemented resulted in an increase in production volumes that was higher than expected, by a total of 7 million euros, thus generating a positive effect on the EBITDA and net profit of 3.7 million euros and 6.8 million euros, respectively (Fig. 5.18). In general, one of the main reasons for the improvement in margins is the result of the shift in the sales mix, compared to the one planned, in favour of the Group’s own brands which, historically, have always recorded higher margins. In particular, the property brands – as a percentage of sales – rose from 67%, in 2013, to 74% in 2015. The other reasons for improved margins were the following:

• • •

the continuous monitoring of production costs at the suppliers’ premises, especially those of the Far East, and the positive effect of the euro/USD exchange rate which allowed the cost of goods to be lower – from an average of 35.8% over the three-year plan – to an effective average of 34.6%; the positive effect of the royalties received on Beta brand licenses, which were higher, compared to the Recovery Plan, in the three-year period under review, for a total value of 1.4 millions euros; the EBITDA was about two percentage points higher than what was expected in the Recovery Plan. Specifically, the average EBITDA in the three-year period was 16.7%, compared to the 15% expected in the Recovery Plan. In absolute terms, on the other hand, the Group generated more than 4 million euros of EBITDA; 1 million euro was due to the increase in volumes (calculated by applying the impact of the Recovery Plan to the final value of production) and 3 million euros to the shift in the sales mix, to cost savings on COGS and to the positive effect of the higher royalties received on the Beta brand.

The Net Financial Position in 2015 is approximately 20 million euros, with a further reduction, compared to the Plan’s objectives, of approximately 7 million euros and with a change from 48.6 million euros on 31 December 2012 to approximately 20 million euros at the end of the Recovery Plan (18 million euros in medium-term debt, including approximately 3.5 million euros in real estate lease) (Table 5.6; Fig. 5.19).

Revenues Gross Margin Margin II Contribution Margin EBITDA EBIT Net Profit

47.444 30.270 17.950 15.109 5.638 2.404 422

RBP 100,0% 63,8% 37,8% 31,8% 11,9% 5,1% -0,9%

45.520 29.711 17.421 14.772 6.593 4.220 56

Fig. 5.16.

2014 Real

100,0% 65,3% 38,3% 32,5% 14,5% 9,3% 0,1%

45.014 29.207 17.278 14.700 7.310 5.090 3.473

RBP 100,0% 64,9% 38,4% 32,7% 16,2% 11,3% 7,7%

46.520 29.860 17.427 14.778 7.161 5.180 1.100

2015 Real

100,0% 64,2% 37,5% 31,8% 15,4% 11,1% 2,4%

48.109 31.933 18.253 15.155 7.949 5.650 2.139

RBP 100,0% 66,4% 37,9% 31,5% 16,5% 11,7% 4,4%

Economic Performance 2013–2015 Plan vs Real.

47.520 29.999 17.166 14.517 7.245 5.381 1.378

Real Forecast 100,0% 54.182 63,1% 35.445 36,1% 20.641 30,5% 16.826 15,2% 9.464 11,3% 7.324 2,9% 3.749

100,0% 65,4% 38,1% 31,1% 17,5% 13,5% 6,9%

The Financial Restructuring of the ‘Alpha’ Group

2013 2012

123

124

Corporate Financial Distress

Ebitda evolu on 2012-2015

17.5%

16.5%

16.2% 11.9%

5,638

6,593

7,310

7,161

7,949

7,245

RBP

Real

RBP

Real

RBP

2012

Fig. 5.17.

2013

2014

9,464

Forecast 2015

EBITDA Trend 2013–2015 Recovery Business Plan (RBP) vs Real.

Revenues, EBITDA and Net Profit - RBP Vs Real 2013-2015 160,0 140,0

+ 7,7 € M 139,6

RBP

147,3

Real

120,0 100,0 80,0 60,0 40,0

21,0

20,0

24,7

Group Revenues

Fig. 5.18.

Group Ebitda

Group Net Profit

Revenues, EBITDA and Cumulated Net Result 2013–2015 Recovery Business Plan vs Real.

As far as equity is concerned, and in relation to the comparison between ratios and covenants, the ratio between NFP and equity increased from an index of approximately 6x, in 2013, to approximately 1.25x in 2015, while the NFP and the EBITDA ratio increased from an index of 3.65x, in 2013, to approximately 2x in 2015, as shown in Fig. 5.20. The management also carried out a benchmark analysis on the main competitors: the result was that Alpha S.p.A.’s income statement, balance sheet and

The Financial Restructuring of the ‘Alpha’ Group

125

Table 5.6. Evolution of NFP 2013–2015 Plan vs Real. 2013 2012

NFP Bank Overdraft Trade Creditors Total Current Liabilities Loans Leasing Total Long-term Liabilities Current Assets

Plan

2014

Real

48.600 34.000 26.710 34.200 6.600 4.547 6.000 1.154 34.200 12.600 5.701

Plan

Real

2015 Plan

Real

30.900 22.181 27.300 19.152 4.000 1.829 3.000 1.005 6.000 449 6.400 3.700 10.000 2.278 9.400 4.705

2.000 16.900 17.071 16.900 17.289 14.300 14.555 18.000 4.500 4.722 4.000 4.033 3.600 3.500 20.000 21.400 21.793 20.900 21.322 17.900 18.055 -5.600

- 784

-

1.419

- 3.608

NFP evolution between 2013-2015 48.600

26.710

-784

-5.600 2012

22.181

-1.419 2013

Current Assets

Fig. 5.19.

Total Current Liabilities

19.152

-3.608 2014

2015 Forecast Loans and leasing

NFP

Evolution of the NFP 2013–2015.

financial data (the company with respect to which the analysis was developed) were aligned, if not better, than those of its competitors. The main indicators and ratios express a clearer outlook on the real performance, in this actual case, of the business. Table 5.7 shows the clear improvement that the company achieved on all the characteristic KPI ratios. The characteristic ratios (NFP/PN, NFP/EBITDA) highlight a higher performance than that established by the covenants as agreed in the Banking Agreement, and that may be clearly appreciated from Figs. 5.21–5.22.

126

Corporate Financial Distress

NFP/NE - NFP/EBITDA 2013 - 2015 RBP Vs Real 6

5,16 3,65

4 3

4,77

4,32

5

2,79

4,1

2,02

3,29

2

2,74

2,55 1,87

1

1,25

0 RBP

Real

Real 2015

2014 NFP/NE

Fig. 5.20.

RBP

Real

RBP

2013

NFP/EBITDA

NFP/PN – NFP/EBITDA 2013–2015 Plan vs Real.

Table 5.7. Characteristic KPI-Ratio 2013–2015 Plan vs Real. SOLIDITY RATIOS

Recovery Business Plan 2013 2014 2015

2013

Actuals 2014

2015

Financial independence (NE/Capital Employed) Share Capital Solidity (Share Capital/NE)

0,146 1,205

0,195 1,027

0,243 0,842

0,296 0,654

FINANCIAL STRUCTURE Investments

2013

2014

2015

2013

2014

2015

- Assets/Capital Employed - Working Capital/Capital Employed

0,348 0,652

0,343 0,657

0,335 0,665

0,417 0,583

0,406 0,594

0,367 0,633

- Current Liabilities/Capital Employed - Long Term Liabilities/Capital Employed - Net Equity/Capitale investito

0,432 0,422 0,146

0,387 0,440 0,173

0,392 0,403 0,205

0,342 0,462 0,195

0,293 0,464 0,243

0,328 0,376 0,296

FINANCIAL SITUATION

2013

2014

2015

2013

2014

2015

Current ratio Elasticity of the financial structure

1,508 0,568

1,700 0,613

1,698 0,608

1,703 0,658

2,027 0,707

1,928 0,672

SELF-FINANCING INDICATORS

2013

0,173 1,064

0,205 0,935

Recovery Business Plan

Actuals

Sources of finance

Recovery Business Plan

Actuals

Recovery Business Plan EBIT/financial charges

2,02

2014 2,77

Actuals

2015 3,17

2013 2,04

2014 3,96

2015 6,01

A signal of greater financial and asset stability is also inferred from the assumed values of Altman’s ‘Z-score’ index which, with a high reliability rate (error rate between 15% and 25%), measures the probability of a company default. It is a quantitative model of empirical nature, designed to detect, in advance, the first symptoms of a state of crisis in order to suggest the necessary

The Financial Restructuring of the ‘Alpha’ Group

Fig. 5.21.

Various Index Relating to the RBP vs Actual (see Previous Table 5.7).

127

128

Corporate Financial Distress

Fig. 5.22.

Financial Covenant 2013–2015 Plan vs Real.

behaviours to stakeholders. This approach fosters the timely formulation of appropriate diagnoses and prognoses of a company’s latent state of crisis. Below are the values of Z-score elaborated in the 2013–2015 period before the start of the Business Recovery Plan, and the comparison between the data from the 2013–2015 Recovery Plan versus the final figures for the same period, in the event of termination of the Banking Agreement and with an outlook to the data from the 2016–2018 business plan. The Z-Score index shows a clear improvement over the three years of the Plan, a sign of greater financial stability and balance sheet equilibrium (Figs. 5.23–5.24). As can be seen from the performance of the Z-score, the new 2016–2018 Plan has continued to express the stability and financial equilibrium already begun in the previous three years but even the performance forecast has positioned the default probability index above the ‘very-low risk’ level of 2.90 in 2017 to continue to grow in 2018. In addition, the most important ratios (NFP/PN and NFP/EBITDA) expressed during the years 2013–2015 and, in perspective, over the 2016–2018 plan period, revealed considerable improvements typical of a healthy company. The trends of these ratios are explained in the following paragraphs.

9. The Prospective Financial Balance: Guidelines and Strategic Objectives of the Post Turnaround Plan (2016–2018) The achievement of the recovery objectives set out in the 2013–2015 Plan, underlying the expected economic, equity and financial performances, the retrieval of profitability and the strengthening of the Alpha Group’s business perspectives, are all signals of the company’s full recovery of profitability with the restoration of economic, equity and financial equilibrium. All the financial equilibrium conditions were achieved by the Group at the end of the 2013–2015 Recovery Business Plan.

Alpha Group - Financial Distress Risk "Z-Score - PMI"

a = Net Working Capital / Total Assets: b = Retained Earnings / Total Assets: c = EBIT / Total Assets: d = Market Value of Equity (**) / Total Liabilities: e = Net Sales / Total Assets: VERY HIGH RISK IF: Z-SCORE < 1.23 MEDIUM-HIGH RISK IF: 1.23 < Z-SCORE < 2.7 MEDIUM RISK IF: 2.7 < Z-SCORE < 2.90 VERY LOW RISK IF : Z-SCORE > 2.90

0,325 -0,010 0,008 0,151 0,624

New Business Plan Forecast 2016 2017 2018

Actuals 2011

2012

1,058

0,986

1,708

1,903

2,305

2,580

3,062

4,559

0,315 -0,003 0,037 0,164 0,653

0,271 -0,006 0,032 0,169 0,628

0,361 0,071 0,104 0,365 0,916

0,358 0,045 0,119 0,535 1,015

0,426 0,078 0,152 0,799 1,127

0,489 0,083 0,147 1,281 1,167

0,502 0,088 0,151 2,275 1,205

0,555 0,093 0,156 5,572 1,261

(*) PMI Z-Score (Italy) (Bottai-Cipriani-Serao) PMI Z-Score: Market Value of Equity = Net Equity

(**)

Fig. 5.23.

Alpha Group – ‘Z-Score PMI’ Distress Risk Index.

New Business Plna - Sensitivity Sensitivity Combined 2016 2017 2018

2,186 2,436 2,914 0,347 0,055 0,114 1,164 1,051

0,364 0,058 0,116 1,637 1,080

0,363 0,060 0,117 2,710 1,103

The Financial Restructuring of the ‘Alpha’ Group

2010

Z-Score = 0.717a + 0.847b + 3.107c + 0.42d + 0.998e = 0,937

Recovery Business Plan Actuals FYTD 2013 2014 2015

(*)

129

130

Corporate Financial Distress

Fig. 5.24.

Alpha Group – ‘Z-Score PMI’ Distress Risk Index 2010 to Forecast 2018.

The Banking Agreement, signed in June 2013, enabled the Group to restore the short-term balance of its financial situation while the Recovery Plan achieved the objective of restoring the Group’s long-term economic, equity and financial equilibrium. However, in order to terminate the Banking Agreement, it was also necessary that the forecast data expressed the ability to maintain and consolidate the balance achieved by the Group during the recovery period. The Plan drawn up by the Group’s directors for the period 2016–2018 had been developed considering an inertial scenario, without taking into account any improvements that could result, inter alia, from market trends (which were expected to grow), strategic initiatives and project activities strongly required by the management (creation of new collections, expansion into foreign markets, etc.). The strategic guidelines adopted in the plan aimed at:

• • • • • • •

consolidating the leadership achieved in the ‘back to school’ sector in the largescale retail channel and increasing penetration in the retail channel; consolidating the focus of commercial strategies on their own brands; granting revenue stability from business licensing through ongoing licenses or long-term agreements with the license owners; optimising production costs through a better and more efficient control of the procurement function; scouting for alternative supply sources, both as regards to suppliers and geographical areas; launching of new projects on boxes and accessories related to the travel, office and leisure world under the Beta brand, to penetrate new sale channels – leather goods and clothing – and expand the reference target – ‘over 20’; diversifying geographical markets through expansion abroad with new projects related to the travel, office and leisure world under the Beta brand;

The Financial Restructuring of the ‘Alpha’ Group

• •

131

optimising the organisational structure through the revision of some functions and their related processes; revising ICT systems and optimising internal processes.

There were no elements or situations which could have conditioned, influenced and, finally, prejudiced the overcoming of the state of crisis, at least in the immediate future. On the contrary, sales were expected to grow at a limited rate over the three years of the plan (2016–2018), and the only increase was due to the inertial forces on the market. The strategic choice continued to be the focus on their own brands, as they grant higher margins. EBITDA was at more than 15%, and the decrease was due to the higher production costs (owing to the unfavourable effect of the Euro/USD exchange rate: 1.15 compared to 1.34 average hedging rate for the 2015 purchases) and to direct commercial costs (an increase in year-end premiums to be paid to the large-scale retail trade). Labour and structural costs did not register any change over the three-year period, as the structure was by then fully up to speed (Fig. 5.25). The financial plan for 2016–2018 highlighted a cash flow dynamic over the three-year period that could further reduce the net financial position to just over 5 million euros (Figs. 5.26–5.27). The new 2016–2018 plan provided for a decrease in working capital due to a reduction in current assets while liabilities remained substantially unchanged. This is due to the effect of the top management’s greater attention to financial dynamics, often neglected, which led to a loss of customers (orders were cancelled for customers exposed or late in payments) but not of revenues, improving the financial soundness (Fig. 5.28). The feasibility of the 2016–2018 business plan, verified through sensitivity analyses and stress tests, was a further confirmation of the Group’s renewed industrial and financial wealth that could support the request to terminate the Agreement. As is well known, sensitivity analyses and stress tests are helpful for the maintenance of any business plan as it is unlikely that the basic assumptions can be fully implemented, both in the envisaged time and manner. Specifically, five scenarios were developed, four of which are the so-called ‘individual’ scenarios, (i.e. with individually selected modified parameters leaving

Fig. 5.25.

EBITDA Bridge 2015–2018.

132

Corporate Financial Distress NFP evolu on 2012-2018E

50.000

48.600

40.000

36.200

30.000

22.772

20.000

19.567

18.000

19.260

16.867

13.108

10.344

10.000 4.722

4.033

3.500

3.139

0 -10.000 -20.000

2012

2013

2014

2015

2016 E

5.025

2.614

2.065

2017 E

2018 E

-5.600

-7.384

Current Asstes

Current and LTbank liabili es

Fig. 5.26.

Leasing

NFP

PFN Trend 2012–2018E.

NFP/EBITDA 2012-2018E 60.000 50.000

8,6

40.000 30.000 3,7

20.000

2,8

10.000

2,6

1,8

1,2

0 2012

2013 2014 NFP and EBITDA 2012-2018

Fig. 5.27.

2015 EBITDA

2016E 2017E NFP/EBITDA

0,6 2018E

PFN/EBITDA 2012–2018E.

NWC evolution 2012 - 2018E 20.000 15.000

11.248 9.400

10.000

9.400

9.300

5.000 0

2012

2016 E

2017 E

2018 E

-5.000 -10.000

-6.804

-5.800

-5.600

Inventory Debtors Creditors NWC (Opera ng)

Fig. 5.28.

NWC Trend.

-5.500

10,0 9,0 8,0 7,0 6,0 5,0 4,0 3,0 2,0 1,0 0,0

The Financial Restructuring of the ‘Alpha’ Group

133

the remaining basic assumptions of the 2016–2018 business plan unchanged), and one is called ‘combined’ scenario, as in this case, all selected parameters are modified at the same time. The ‘combined’ scenario is useful to simulate a situation of greater stress on the plan in order to assess the probability that a situation of possible default may occur. The operational parameters used in the scenarios and the criteria for the sensitivity assumptions were as follows:

• • • • •

Sensitivity 1: decrease in turnover, decreasing the volume through the number of accessories sold; Sensitivity 2: increase in the cost of sales (lower margins), increasing the industrial cost (production, duties and freight) of accessories; Sensitivity 3: worsening of working capital, increasing the days of collection (DSOs) of retail channel invoices; Sensitivity 4: worsening of working capital: increasing the days for collection of invoices from the ‘normal trade’ channel (DSO); Sensitivity Combined: simultaneous application of all the previous hypotheses but with a lower degree of worsening compared to the individual scenarios, to take into account the simultaneity of the hypotheses that, in a reasonable situation, would imply the management action that, in such a scenario, has not been considered.

By applying the scenario assumptions to the quantitative model of the plan, the economic–financial–capital performance has been recalculated with a check on the characteristic elements (KPIs) to verify the going concern conditions, i.e. Net Cash Flow End-of-Period (EoP); Net Financial Position/ EBITDA Ratio (NFP/EBITDA); Net Financial Position/Net Equity Ratio (NFP/NP). Tables 5.8–5.9 summarise, for each year in the plan, the performance results of the various scenarios with evidence of the KPIs as mentioned above. As can be seen in all the worsening scenarios, the resulting performance expressed the business continuity conditions not only for the Net Cash Flow EoP values, always positive, but also for the capital ratios for which a comparison was made with the 2015 covenants, as agreed in the Banking Agreement dated 14 June 2013. These scenarios confirmed that the business plan held up well, a reason that led the credit institutions to agree to conclude the Banking Agreement as requested by the Group, by bringing the positions of the Group companies back to their internal credit ratings. Actually, while the structural actions of the 2013–2015 Recovery Plan brought the Group out of the crisis, those implemented in 2016–2018 resulted in significant commercial, image, economic, capital and financial benefits to the point of inducing the management to go beyond national borders and face new challenges on international markets.

134

Table 5.8. Sensitivity and Stress Test Plan 2016–2018 Analysis Criteria.

Business Plan - Base Scenario 2016 726.451 DRIVERS SCENARIOS 2015

SENS - 1: School products SENS - 2: COGS SENS - 3: Period of credit given to debtors - DSO vs GDO SENS - 4: Period of credit given to debtors - DSO vs Retail

Unit

n° €/unit n° days n° days

Individual 653.806 15.48 110 195

%

Delta vs. BP

-10% - 72.645 10% 1 30% 45

Combined 690.128 14.78 121 173

COGS per backpack*

DSO channel GDO

DSO Channel Retail

14.08

110

150

COGS per backpack*

DSO channel GDO

DSO Channel Retail

%

Delta vs. BP

N. backpack selled

-5% 5% 10% 15%

- 36.323 1.41 11 23

653.806

14.08

110

150

726.451

15.48

110

150

726.451

14.08

110

150

726.451

14.08

110

195

690.128

15

121

173

SENS-Combined [Stress test]

*It includes the cost of production, duties and freight N. backpack selled

Business Plan - Base Scenario 2017 732.468 DRIVERS SCENARIOS 2016

SENS - 1: School products SENS - 2: COGS SENS - 3: Period of credit given to debtors - DSO vs GDO SENS - 4: Period of credit given to debtors - DSO vs Retail

Unit

n° €/unit n° days n° days

Individual 659.221 15.83 132 195

%

Delta vs. BP

-10% - 73.247 10% 1 20% 22 30% 45

Combine d 695.844 15.11 121 173

SENS - 1: School products SENS - 2: COGS SENS - 3: Period of credit given to debtors - DSO vs GDO SENS - 4: Period of credit given to debtors - DSO vs Retail

SENS-Combined [Stress test]

Unit

n° €/unit n° days n° days

Individual 664.945 16.17 132 195

%

Delta vs. BP

-10% - 73.883 10% 1 20% 22 30% 45

Combined

701.886 15.44 121 173

DSO Channel Retail

14.39

110

150

DSO channel GDO

DSO Channel Retail

659.221

14.39

110

150

732.468

15.83

110

150

732.468

14.39

132

150

732.468

14.39

110

195

695.844

15

121

173

N. backpack selled

COGS per backpack*

DSO channel GDO

DSO Channel Retail

%

N. backpack selled

-5% 5% 10% 15%

- 36.623 1.44 11 23

Business Plan - Base Scenario 2018 738.827 DRIVERS SCENARIOS 2017

DSO channel GDO

COGS per backpack*

Delta vs. BP

SENS-Combined [Stress test]

COGS per backpack*

14.70

110

150

COGS per backpack*

DSO channel GDO

DSO Channel Retail

664.945

14.70

110

150

738.827

16.17

110

150

738.827

14.70

132

150

738.827

14.70

110

195

701.886

15

121

173

%

Delta vs. BP

N. backpack selled

-5% 5% 10% 15%

- 36.941 1.47 11 23

Corporate Financial Distress

N. backpack selled

Table 5.9. Sensitivity and Stress Test Plan 2016–2018 Analysis. Outcome Check: "Final Net Cash" "WHAT-IF" SCENARIOS

55.836 52.632 55.836 55.836 55.836 54.234

47.149 45.275 48.198 47.149 47.149 46.711

8.687 7.357 7.638 8.687 8.687 7.523

8.906 7.808 8.016 6.887 7.313 7.931

Outcome Check: "Final Net Cash" "WHAT-IF" SCENARIOS BUSINESS PLAN 2017 SENS - 1: School products SENS - 2: COGS SENS - 3: Period of credit given to debtors - DSO vs GDO SENS - 4: Period of credit given to debtors - DSO vs Retail SENS - COMBINED: Stress Test

Revenues 56.836 53.565 56.836 56.836 56.836 55.200

Total Final Net EBITDA costs Cash 48.072 46.141 49.147 48.072 48.072 47.617

8.763 7.424 7.688 8.763 8.763 7.583

9.450 6.881 7.519 7.337 8.061 7.236

Outcome Check: "Final Net Cash" "WHAT-IF" SCENARIOS BUSINESS PLAN 2018 SENS - 1: School products SENS - 2: COGS SENS - 3: Period of credit given to debtors - DSO vs GDO SENS - 4: Period of credit given to debtors - DSO vs Retail SENS - COMBINED: Stress Test

Revenues 57.836 54.497 57.836 57.836 57.836 56.166

Total Final Net EBITDA Cash costs 49.050 47.060 50.149 49.050 49.050 48.576

8.786 7.438 7.686 8.786 8.786 7.590

11.575 7.590 8.531 8.979 10.067 7.934

Outcome Check: Sanity check (Hp: "covenant 2015") Max NFP/NE Max NFP NFP/EBITDA covenant NE covenant 2015 2015 15.297 1.76 3.80 19.600 2.50 2.50 15.782 2.15 3.80 18.270 0.86 2.50 15.937 2.09 3.80 18.551 0.86 2.50 18.846 2.17 3.80 19.600 0.96 2.50 15.766 1.81 3.80 19.600 0.80 2.50 15.839 2.11 3.80 18.437 0.86 2.50

Outcome Check: Sanity check (Hp: "covenant 2015") NFP/NE Max Max covenant NFP NFP/EBITDA covenant NE 2015 2015 10.460 1.19 3.80 23.800 2.50 2.50 13.266 1.79 3.80 21.089 0.63 2.50 12.982 1.69 3.80 18.006 0.72 2.50 14.003 1.60 3.80 23.800 0.59 2.50 10.944 1.25 3.80 23.800 0.46 2.50 13.086 1.73 3.80 21.424 0.61 2.50

Outcome Check: Sanity check (Hp: "covenant 2015") Max Max NFP NFP/EBITDA covenant NE NFP/NE covenant 2015 2015 2.50 5.025 0.57 3.80 28.000 2.50 9.199 1.24 3.80 23.999 0.38 2.50 8.620 1.12 3.80 27.158 0.32 2.50 9.040 1.03 3.80 28.000 0.32 2.50 5.541 0.63 3.80 28.000 0.20 2.50 9.034 1.19 3.80 24.486 0.37 2.50

The Financial Restructuring of the ‘Alpha’ Group

BUSINESS PLAN 2016 SENS - 1: School products SENS - 2: COGS SENS - 3: Period of credit given to debtors - DSO vs GDO SENS - 4: Period of credit given to debtors - DSO vs Retail SENS - COMBINED: Stress Test

Revenues

Total Final Net EBITDA costs Cash

135

136

Corporate Financial Distress

10. From Financial Crisis to Value Creation: The Search for a Partner to Foster International Growth The success of the 2013–2015 Recovery Plan, certified in June 2013, made it possible to preserve the continuity of the Group’s business as a going concern, and avoid the spread of the crisis situation to the whole system. The defence and reconstruction of the value of the Alpha Group was possible thanks to structural, specific and far-reaching actions that involved both the company functions, the different processes, the entire management, and the resources employed at the various levels of the organisation, by influencing, above all, their behaviour. In order to benefit from future value increases, it was fundamental for the Group to take a strategic attitude towards the future, with the awareness that the countless product, process and service potentials (research, development, innovation) would allow it to continue to enjoy the trust and consensus of the market (customer satisfaction) while consolidating its leadership in Italy and spreading its value abroad. More than 5 years after the implementation of the Recovery Plan strategy, the Group reached a consolidated turnover of 80 million euros in 2017 (10 million euros of which from licenses), an increase of 30% over the previous three years. With constant growth, stable profitability and a significant increase in the company’s reputation and image in the world, there has been a real change of direction over the years, which, in 2018, encouraged the Group to consider an international expansion strategy. In October 2018, Alpha issued a press release announcing the acquisition of 55% of the company’s shares by a private equity fund. The objective of the partnership was the provision of financial support for an international expansion with a particular focus on the American market and on the Asian countries, in addition to consolidating the market positioning of Beta-branded products in the premium segment. The Group has identified a partner to share an ambitious 2018–2022 industrial plan which aims to exceed 100 million euros in turnover, with a significant presence abroad, especially through the spread of the Beta brand both for satchels and accessories and for clothing.

11. Conclusions The Alpha Group’s recovery process highlights how, by facing a turnaround process from a strategic point of view, searching for unexpressed potential within the company system, exploiting industrial and financial synergies and identifying new market opportunities, it is possible to achieve a complete reversal of a situation of imbalance. The results achieved at the end of 2015 show, in fact, how a reversal trend is possible through specific actions focused on the recovery of profitability and on the value creation, and how that progressively affects functions, processes and the

The Financial Restructuring of the ‘Alpha’ Group

137

whole management. For a successful recovery plan, simple recipes – made up only of staff cuts and/or unprofitable activities (products, segments, consumer groups and geographical areas) – are not enough: an ‘organic’ recovery needs to be implemented. In the recovery process, the accurate survey carried out in 2013 on the Alpha Group’s corporate structure revealed the areas to act upon with rapid implementation, as well as the Group’s latent potential and strengths, to craft a successful turnaround. The Group made radical changes in the organisational model. In the period 2013–2015, the choice of some specific guidelines, in the Business Recovery Plan, proved to be fundamental for the achievement of the expected results. Among them, we have to especially highlight:

• • • •

revision of Beta’s business model; development of appropriate commercial strategies aimed at consolidating the leadership in the sector and at penetrating new market niches, close to the core business; continuous monitoring of production costs, especially at suppliers in the Far East; renegotiation of payment (suppliers) and collection times (customers) to reduce the working capital requirements.

Lastly, it should be noted that the recovery process identified all the responsibilities for each phase of the process, thus allowing the company management to periodically check the correct fulfilment of the actions and monitor the progress towards the desired objectives. The problems regarding the Group’s crisis represented the opportunity to achieve a deep internal reorganisation, a targeted cost rationalisation, a debt restructuring and a renewed commercial policy. The turnaround did not focus on resolving the expressive symptoms of the crisis, but aimed at improving the overall management of the company. The turnaround strategy was successful and allowed interesting development opportunities to be taken at the right time even during a difficult period.

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Index Administrative systems, 82–84 Alpha Group causes, 105–109 commercial objectives, 118–119 customer segments, 104 distribution channel, 103 economic objectives, 118–119 elements, 102 endogenous causes, 107–109 equity objectives, 118–119 exogenous causes, 105–107 financial crisis situation, 118 financial intervention, 114–118 financial objectives, 118–119 financial/strategic recovery plan, 109–114 market dimensions, 104 prospective financial balance, 128–134 recovery phase performance, 119–128 reference market, 102–105 reference target, 103 value creation, 136 Balance sheet, 48 Banking Agreement, 130 Bankruptcy prediction administrative systems, 82–84 Bocconi University, 88–94 business administrative systems (BAS), 81–88 cash flows predictive ability, 94–97 cash flow statements, 70 company recovery, 68–69 company stakeholders, 67 corporate crises, 79–81 data source, 94–95

extrajudicial renegotiation, 79 IAS/IFRS situation, 77 Italian listed companies, 73–78 Observatory on Corporate Crisis (OCI), 81 operating cash flow (OCF), 75–77 Parthenope University, 88–94 procedures, 29 regression model, 92, 95 reorganisation strategies, 82–84 Spearman’s analysis, 73 theoretical/empirical research work, 68–69 University of Pisa, 69–73 variable description, 86–87 Z-Score model, 68 Beta’s business model, 110 Bocconi University, 88–94 Bridge finance, 47 Business administrative systems (BAS), 81–88 Business distress, 11–23 Business model, 27 Business planning process, 44 Business turnaround plan, 43–50 Cash flows predictive ability, 94–97 Cash flow statements, 70 Chief Restructuring Officer (CRO), 57 Company pathologies, 7 Company value, recovery plans balance sheet, 48 business model, 27 business planning process, 44 business turnaround plan, 43–50 cash-based approaches, 40 CNDCEC, 32–37 completeness principle, 34 continuity, 28

162

Index

debt rescheduling, 47 feasibility, 32–37 financial restructuring, 47 financial situation analysis, 49 forecast income statement, 47–48 Italian Stock Exchange, 33 liquidity statement, 49 managerial intervention, 38–39 neutrality principle, 34 restructuring, 25 self-realisation, 27 transparency, 34 turnaround strategy, 37–43 Contingency, 65 Corporate financial distress crisis factors, 7–10 crisis path, 6 crisis stages, 5, 6 definition, 1, 4–7 external causes, 9–10 governance, 7–10 Guatri’s approach, 5 handling, 7–10 holistic vision, 9–10 identification, 7–10 inefficiency crisis, 8 innovation, 9 internal causes, 8–9 optimal capital structure, 1 overcapacity crisis, 9 planning, 9 product-related crisis, 9 time factor, 7–8 Corporate governance activities, 22 COVID-19 pandemic effects, 25 Data processing, 7 Debt rescheduling, 47 Delta-KPI, 63 Delta-Performance scheme, 61 Deployment action plan, 62–63 EBITDA, 43, 61, 80, 122, 124 Economic balance, 11

External communication phase, 53 Extrajudicial renegotiation, 31, 79 Financial equilibrium assessment, 22–23 capital balance, 11 complementarity, 14–17 constant variability, 11–14 convenient financial structure, 18–22 coverage methods, 16 economic balance, 11 financial balance, 11 financial requirements, 11–14 interdependence, 14–17 short-term financial equilibrium, 23 Financial restructuring, 47 Financial situation analysis, 49 Financial/strategic recovery plan, 109–114 Forecast income statement, 47–48 Insolvency management system, 28–29 Internal operations, 36–37 Italian listed companies, 73–78 Italian Stock Exchange, 32, 33 KPI scorecard monitoring, 59 Liquidity statement, 49 Net financial position, 124 Observatory on Corporate Crisis (OCI), 81 Operating cash flow (OCF), 75–77 Ordinary Redundancy Fund, 37 Organisational balance, 11 Organisational infrastructure, 57–58 Organisational recovery, 56–60 Organisational redesign, 56 Out-of-court agreement, 30

Index Parthenope University, 88–94 Prospective financial balance, 128–134 Recovery Business Plan (RBP), 52, 64–66 Recovery phase performance, 119–128 Recovery project Chief Restructuring Officer (CRO), 57 Delta-Performance scheme, 61 deployment action plan, 62–63 development, 53 external communication phase, 53 feasibility, 60–63 macro phase, 51 monitoring framework, 65 organisational change, 58 organisational infrastructure, 57–58 organisational leadership, 58 organisational recovery, 56–60

163

Recovery Business Plan (RBP), 52, 64–66 sensitivity analysis, 62 Reduced/cancelled liabilities, 26 Reference market, 102–105 Regression model, 92, 95 Reorganisation strategies, 82–84 Satisfactory profitability, 21–22 Self-financing, 23 Sensitivity analysis, 62, 133 Short-term financial equilibrium, 23 Spearman’s analysis, 73 University of Pisa, 69–73 Value creation, 136 Variable description, 86–87 Z-Score model, 68

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