Detecting Insolvency Detecting Insolvency David Emanuel 1 4 - - PowerPoint PPT Presentation

New Zealand Governance Centre New Zealand Governance Centre SMEs and Family Business Conference

“Detecting Insolvency” “Detecting Insolvency”

David Emanuel 1 4 August 2 0 0 9

Outline of presentation Outline of presentation

• Solvency defined and issues that arise from
• Solvency defined, and issues that arise from

an accounting perspective.

• Some general issues that affect SMEs
• Some general issues that affect SMEs.
• Keeping as clear as one can from insolvency.

Solvency defined – Com panies Act Solvency defined Com panies Act

• 4 Meaning of solvency test

g y

• (1) For the purposes of this Act, a company

satisfies the solvency test if—

– (a) The company is able to pay its debts as they become due in the normal course of business; and (b) The value of the company's assets is greater than – (b) The value of the company's assets is greater than the value of its liabilities, including contingent liabilities.

• The Financial Reporting Act is relevant here.

Reckless trading ec ess t ad g

• Reckless trading
• A director of a company must not—

– (a) Agree to the business of the company being carried on in a manner likely to create a substantial carried on in a manner likely to create a substantial risk of serious loss to the company's creditors; or – (b) Cause or allow the business of the company to be carried on in a manner likely to create a substantial risk of serious loss to the company's creditors.

Accounting Principles ccou t g c p es

Some things may seem strange. Here is an illustration.

Balance Sheet Debt 100 Assets 300 Equity 200 300 300 Take a high human capital investment company, so there is not much on the balance sheet. Consultancy Biotech IT network company NZRU Consultancy, Biotech, IT, network company, NZRU. Say the cash flows are expected to be 160 USD Say the exchange rate is expected to be 0.6

Accounting Principles ccou t g c p es

So the $NZ cash flow is expected to be 266.67 p a Say the required rate of return is 0.1 So the "market value" of the company is 2666.67 Say for ward rates equal spot rates And the company hedges five years expected CFs Initial value of the forward contract is

Accounting Principles ccou t g c p es

Now let us assume that the $NZ falls 0.5 Now let us assume that the $NZ falls 0.5 So the unhedged cash flow in $NZ is 320 So the "market value" of the company is 3200 unhedged However the hedge value is now negative However the hedge value is now negative Obligation is to deliver more valuable USDs ‐202.18 So the "market value" of the company is 2997.82 So the value has changed by 12.42%

Accounting Principles ccou t g c p es

However the hedge value is now negative However the hedge value is now negative Obligation is to deliver more valuable USDs ‐202.18 So the "market value" of the company is 2997.82 So the value has changed by 12.42% So the value has changed by 12.42% But the book value (balance sheet position) is: Debt 302.18 Assets 300.00 Equity ‐2.18 300.00 300.00

Accounting Principles

Operating Leases Say the company leases assets. They may have to be valued Say the leases have a present value of 100 Thi ill i INTANGIBLE b 100 This will increase INTANGIBLE assets by 100 And increase liabilities by 100 New book value (balance sheet position) Debt 200 Assets 400 Equity 200 400 400

Scoring Models – Altm an’s m odel Sco g

• de s

t a s

• de

■ Matched bankrupt and non-bankrupt firms on size and industry industry ■ Z-score = 1.2NWC/ TA + 1.4RE/ TA + 3.3EBIT/ TA + 0.6MVEQ/ BVL + 1.0S/ TA ■ NWC/ TA – short-term liquidity risk ■ RE/ TA – accumulated profitability and relative age of a firm firm ■ EBIT/ TA – ROA, profitability ■ MVEQ/ BVL – market’s assessment of profitability and Q p y risk ■ S/ TA – use of assets to generate sales Z increasing > “good” ■ Z increasing = > “good”

Scoring Models – Ohlson’s m odel Sco g

• de s

O so s

• de

■ Ohlson used 105 bankrupt and 2,058 non- b k t fi bankrupt firms ■ y = – 1.32 – 0.407SIZE + 6.03TL/ TA 1 43WC/ TA + 0 0757CL/ CA – 1.43WC/ TA + 0.0757CL/ CA – 2.37NI/ TA –1.83FU/ TL + 0.285NIL2YR – 1.72TL> TA + 0.285NIL2YR 1.72TL> TA – 0.521CHNI/ SUMABSNI

• y increasing = > “bad”; y = ln(P/ (1-P))

y g ; y ( / ( ))

• P is the probability of bankruptcy.

W hat do w e learn from scoring m odels?

• Not a lot from the detailed structure.
• Quite a lot from the variables that are on the

h h d d f h l right hand side of the equals sign.

• Of course, most of those variables are

i i unsurprising.

An accounting and finance “take”

• n SMEs
• Ability to raise (additional) capital is

Ability to raise (additional) capital is constrained.

• It is more difficult to establish “value” and

h l h bl f hence easier to leave money on the table if new outside equity is raised.

• There are generally fewer “agency” issues
• There are generally fewer agency issues.
• On average owners are less well diversified

and this may have implications for required y p q rates of return on investment decisions, and hence on the values placed on assets.

Keeping as clear as one can from insolvency - an accounting and so e cy a accou t g a d finance “take” on SMEs

C it l t t i i l

• Capital structure principles.
• The higher the FC/ VC ratio, the lower the relative debt

levels should be.

• The higher the anticipated volatility of earnings, the less

the debt levels should be. Th hi h th th ti th l th t d bt

• The higher the growth options, the less the current debt

levels should be.

• The longer the duration of the assets, the longer the

g , g duration of the debt should be.

• If value is a (positive) function of a foreign currency, the

more sense there is in borrowing in that currency more sense there is in borrowing in that currency.

Keeping as clear as one can from i l ti d insolvency - an accounting and finance “take” on SMEs

• Risk return principles.
• If your business operates in more than one
• If your business operates in more than one

industry segment, look at using differing hurdle rates for investment decisions and hurdle rates for investment decisions and performance evaluation (and related pay issues).

• Of course, this does not tell anyone what

those different rates should be.

E t d Expected return B A WACC WACC risk risk

Keeping as clear as one can from insolvency - an accounting and insolvency an accounting and finance “take” on SMEs

• Required returns.
• Most “models” for computing required returns assume

that investors are well diversified that investors are well diversified.

• The best known model is the capital asset pricing model

(CAPM).

• That is commonly used for listed public companies, and

is used by regulators (for example the Commerce Commission). )

• The risk metric in the CAPM is known as “beta” and

measures the risk of an asset as its contribution to the risk of the market portfolio risk of the market portfolio.

Required returns q

• But if the owner is poorly diversified, as is likely the

case with SMEs and family businesses, she will need a higher return than suggested by the CAPM.

• Extreme cases of that will be new ventures (so we can
• Extreme cases of that will be new ventures (so we can

look at what venture capital partnerships require (and don’t always get)). Fi hi i d l f i

• Fishing companies are a good example of companies

that have low beta coefficients but high idiosyncratic risk.

• Family owners are unable to diversify (so much) so will

not value the cash flows so highly.

Expected return p E*

}

x ECAPM

}

Additional return required Risk volatility Risk - volatility

DST DST

• Dynamic solvency techniques.
• These techniques are used by actuaries in the insurance

sector and by banks and their regulators sector, and by banks and their regulators.

• But simplified versions of the same ideas can be applied

across the board without it costing a fortune.

• All modelling involves thinking carefully about the

business model, and that is not a bad thing.

• It is then reasonably straight forward to set yourself up

It is then reasonably straight forward to set yourself up to use DSTs via sensitivity analysis or simulation.

The business m odel The business m odel

• How you organise your business can be extremely

important in many settings.

• This is not just a large company issue.
• It’s at the core of the centralisation

decentralisation

• It s at the core of the centralisation – decentralisation

debate.

• Decentralisation decisions involve thinking about where

knowledge lies and whether it can be transported to the centre without large losses of content occurring.

• In turn one needs to think about
• In turn one needs to think about

– The allocation of decision rights – How performance is evaluated – How people are paid