Tag Archives | liquidation

Reorganization Definition

See Also:
Debtor in Possession
Financial Distress Costs
Insolvency

Reorganization Definition

Reorganization is when a bankrupt company restructures its debt obligations without going out of business. During reorganization, the debtor retains ownership of its assets and continues business operations. The debtor then renegotiates the terms of its debt obligations to creditors. If a company is having financial trouble and is at risk of defaulting on loan payments, that company may want to consider reorganization to consolidate debts and adjust loan agreements to make payments more manageable.

Reorganization vs Liquidation

Reorganization vs liquidation are two types of bankruptcy processes. In a reorganization, the debtor retains ownership of its assets and continues business operations while renegotiating debt repayments with creditors.

In a liquidation, the creditors seize control of the debtors assets and sell them to pay off the debt. Furthermore, the debtor goes out of business and ceases normal operations. After liquidation, the entity technically no longer exists.

Chapter 11 Reorganization

Chapter 11 bankruptcy is a type of bankruptcy proceeding outlined in the Bankruptcy Code. It is also a reorganization procedure.

When a financially distressed entity files for chapter 11 bankruptcy, the entity continues to operate while it restructures its debt obligations. The entity is given a limited amount of time in which to restructure the debts. During this time the entity is protected from creditors.

Reorganization bankruptcies are usually more complex than liquidation bankruptcies. Companies usually file for Chapter 11 bankruptcy.

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Reorganization Definition, Reorganization vs Liquidation

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Reorganization Definition, Reorganization vs Liquidation

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Liquidation Valuation

See Also:
Bankruptcy Information
Chapter 11 Bankruptcy
Bankruptcy Chapter 12
Chapter 13 Bankruptcy
Chapter 7 Bankruptcy
Bankruptcy Costs
How to Make Dramatic Changes in Business
Bankruptcy Courts

Liquidation Valuation Definition

Liquidation valuation is the value of a company that is bankrupt or going out of business. It is the value of the company’s assets, according to what they would be worth if they are sold off in order to repay creditors. This is in contrast to going concern value, which assumes the company will continue to operate for the foreseeable future. The difference between going concern value and liquidation value consists of intangible assets and goodwill.

Liquidation Valuation Example

For example, if a well-known apparel company is going out of business, it would have to sell off its assets – sewing machines, fabric, etc. – to pay creditors. The company would probably have to sell off its assets at a discount. In this case, the company would be valued according to its liquidation value. However, if the company is a going concern, it can continue to sell its brand-name clothing at a markup for a profit. It would then be valued according to its going concern value.

 

 

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Liquidation Valuation

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Liquidation Valuation

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Debtor in Possession

Debtor in Possession

A debtor in possession, or DIP, is a company undergoing a Chapter 11 bankruptcy reorganization. In Chapter 11 bankruptcy, the debtor remains in possession of its assets and continues normal business operations while reorganizing debt obligations and repayment plans. This is in contrast to a Chapter 7 liquidation, in which the debtor’s assets are sold to pay off debts and the bankrupt company ceases operations. In some cases, debtor-in-possession may refer to a legally appointed trustee, someone other than the actual company that is in bankruptcy, who oversees the assets during the reorganization.

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debtor in possession

See Also:
Chapter 11 Bankruptcy
Chapter 12 Bankruptcy
Bankruptcy Costs
Bankruptcy Courts
Chapter 13 Bankruptcy
Bankruptcy Code
Bankruptcy Information
Secrets of Successful Out of Court Debt Restructures
Tips on How to Manage your Lawyer
Relationship With Your Lender

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Bankruptcy Information

See Also:

Chapter 7 Bankruptcy
Chapter 11 Bankruptcy
Bankruptcy Code
Chapter 13 Bankruptcy
Bankruptcy Costs
Chapter 12 Bankruptcy
Courts – Bankruptcy

Bankruptcy Information

Bankruptcy is the legal condition of being unable to repay debts. It can apply to individuals or organizations. There are two types of bankruptcy: voluntary and involuntary.

Voluntary bankruptcy occurs when the debtor, the party that owes money, files for bankruptcy. Involuntary bankruptcy occurs when the creditor – the party owed money – files a petition for bankruptcy against the debtor. Voluntary bankruptcy is more common than involuntary bankruptcy.

The idea is to settle the debtor’s debts in an orderly manner that forgives the debt and at least partially repays the creditors. When an entity files for bankruptcy, the creditor values the assets. Then they make arrangements to pay off all or some of the entity’s outstanding debt. After successfully completing the bankruptcy proceedings, the debtor is relieved of its prior debt obligations. This allows them to resume operations.

Bankruptcy laws are stated in the chapters of the Bankruptcy Code. These proceedings take place in Bankruptcy Court.

Bankruptcy Pros & Cons

There are advantages and disadvantages of bankruptcy proceedings. First, filing for bankruptcy allows an entity facing financial distress to settle its debts and essentially start over again. Second, bankruptcy regulations allow creditors to collect at least a portion of what is owed to them. Also, bankruptcy regulations are a sort of safety net, encouraging entrepreneurial individuals and businesses to take risks.

On the other hand, bankruptcy proceedings are expensive for the debtor. An entity filing for bankruptcy may incur legal costs, operational inefficiencies, asset write-downs and liquidation losses, and a higher cost of capital. Also, in bankruptcy proceedings, creditors rarely recoup the full amount owed to them.

Although bankruptcy can be great option for a company with no end in sight, we need to start looking at the valuation aspect. Download the Top 10 Destroyers of Value to maximize the value of your company.

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Bankruptcy Code

See Also:
Chapter 7 Bankruptcy
Chapter 11 Bankruptcy
Bankruptcy Costs
Bankruptcy Courts
Chapter 12 Bankruptcy
Chapter 13 Bankruptcy
Bankruptcy Information

Bankruptcy Code

U.S. bankruptcy laws are stated in U.S. Code Title 11 also referred to as the Bankruptcy Code. The code consists of several chapters outlining different bankruptcy categories and procedures. Based on the debtor’s circumstances, the financially distressed debtor can file for bankruptcy under the appropriate chapter. Bankruptcies usually fall into one of two categories, either liquidation or reorganization. Furthermore, bankruptcy proceedings take place in Bankruptcy Courts.

Title 11 – Bankruptcy Code

The chapters of U.S. Code Title 11 include the following:

If you want more details regarding US Code Title 11, then go to: uscode.house.gov

Whether you are facing bankruptcy or are trying to sell, it important to get as much value as possible. If you are in that situation, then click here to download the Top 10 Destroyers of Value to maximize the value of your company as you reorganize or exit.

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Capital Impairment Rule

See Also:
Dividends
Dividend Payout Ratio
Dividend Yield
Capital Structure Management
Balance Sheet

Capital Impairment Rule

The capital impairment rule is a state-level legal restriction on corporate dividend policy. The rule applies in most U.S. states. It basically limits the amount of dividends a company can pay out to shareholders. The limit is described as either a limit per capital stock or per the par value of the firm. Essentially, for a given amount of capital stock or a given firm value, there is a maximum limit to the value of dividends that a company can distribute to stockholders.

The purpose of the rule is to protect claims of creditors who have lent money to the firm in question. The idea is that a troubled firm, one that is in default or on the brink of bankruptcy, must not be able to unload cash to owners and shareholders before going out of business. Doing so would leave debt holders and creditors high and dry, or at least diminish the amount of value they could recoup from their loans. The capital impairment rule, by limiting the dividend payout, ensures that creditors will be able to reclaim a larger portion of their loans in the event of default or liquidation.

capital impairment rule

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5 Cs of Credit (5 Cs of Banking)

See Also:
What are the 7 Cs of banking
How to Manage Your Banking Relationship
Line of Credit
Trade Credit
Collateralized Debt Obligations

5 Cs of Credit (5 Cs of Banking)

The 5 Cs of credit or 5 Cs of banking are a common reference to the major elements of a banker’s analysis when considering a request for a loan. Namely, these are Cash Flow, Collateral, Capital, Character, and Conditions. Below is an in-depth description of each of the 5 Cs of credit or banking to help you understand what your banker needs to understand about your business in order to approve your loan. You will have insight as to where your banker is coming from and will therefore better prepare you to handle their questions and concerns.

Cash Flow
Collateral
Capital
Character
Conditions

Cash Flow Importance

Cash Flow After Tax is the first “C” of the 5 Cs of credit (5 Cs of banking). Your banker needs to be certain that your business generates enough cash flow to repay the loan that you are requesting. Therefore, your banker will be looking at your company’s historical and projected cash flow and compare that to the company’s projected debt service requirements. There are a variety of credit analysis metrics used by bankers to evaluate this, but a commonly used methodology is the “Debt Service Coverage Ratio” generally defined as follows:

Debt Service Coverage Ratio = EBITDA – income taxes – unfinanced capital expenditures divided by projected principal and interest payments over the next 12 months

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Historical Ability to Service Debt

Typically, the bank will look at the company’s historical ability to service the debt. Your company’s past 3 years free cash flow will be compared to your projected debt service. In addition, they will compare free cash flow to the past twelve months to the extent your company is well into its fiscal year. While projected cash flow is important, the banker will generally want to see that the company’s historical cash flow is sufficient to support the requested debt. Usually projected cash flow figures are higher than historical figures due to expected growth at the company; however, your banker will view the projected cash flows with skepticism as they will generally entail some level of execution risk.

If your historical cash flow is insufficient, the banker must rely on your projections. Therefore, you must be prepared to defend your future cash flow projections with information that would give your banker visibility to future performance, such as backlog information.

Margin of Error

The banker will also want a comfortable margin of error in the company’s cash flow.

A typical minimum level of Debt Service Coverage is 1.2 times.

This means that the company is expected to generate at least $1.20 of free cash flow for each dollar of debt service. This margin of error is important. The banker wants to be comfortable. If there is a blip in the company’s performance, they want to know that the company will still meet its obligations.


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Importance of Collateral

In most cases, the bank wants the loan amount to be exceeded by the amount of the company’s collateral. The reason the bank is interested in collateral is because it acts as a secondary source of repayment of the loan. If the company is unable to generate sufficient cash flow to repay the loan at some point in the future, the bank wants to be comfortable that it will be able to recover its loan by liquidating the collateral and using the proceeds to pay off the loan.

Assess Available Collateral

How doest the banker assess your company’s available collateral? It is common place for borrowers to think that the bank will lend a dollar for every asset that their company owns. This is not the case.

Certain Asset Classes

First, the banker is interested in only certain asset classes as collateral – specifically accounts receivable, inventory, equipment and real estate – since in a liquidation scenario, these asset classes can be collected or sold to generate funds to repay the loan. The banker will not consider other asset classes as collateral. Since in a liquidation scenario, they would not fetch any meaningful amounts. These asset classes include goodwill, prepaid amounts, investments, etc.

In the case of accounts receivable, the debtor (your company’s customer to whom a good was sold or service rendered) is legally required to pay their bill with the company, and in a liquidation scenario the bank will collect the accounts receivable and use those amounts to pay down the loan. In the case of inventory, equipment and real estate, the bank can sell these assets to someone else and use the proceeds to pay down the loan.

Historical Liquidation Values

Secondly, the bank will discount or “margin” the value of the collateral based on historical liquidation values. For example, bank’s will generally apply margin rates of…

  • 80% against accounts receivable
  • 50% against inventory
  • 80% against equipment
  • 75% against real estate

These advance rates are not arbitrary. These are the amounts that in the bank’s historical experience they have realized in a liquidation scenario against the respective asset class. While you might think that your accounts receivable would collect 100% on the dollar, the amounts have actually been historically closer to 80%. In liquidation scenarios, account debtors will come up with reasons why they don’t owe the entire amount. Or worse, they won’t pay at all and force the bank to sue them for collection.

The amount of the receivable would be exceeded by the legal costs of collection in some cases, and thus the bank simply won’t pursue collection. In the case of inventory, 50 cents on the dollar is usual since the buyers of this inventory know that it is a distressed sale and are in a position of leverage to buy the goods for less than what it cost you to buy them.

Third Party Appraisals

In the case of equipment and real estate collateral, the bank needs a completed third party appraisal on these assets. The bank will margin the appraised value of these asset classes to determine the amount of the loan… As opposed to using the company’s carrying value of these assets on its balance sheet. You will be responsible for the cost of third party appraisals. So, be sure to factor in the time needed to complete the appraisals.

Due Diligence

Also, the bank will in many cases want to complete due diligence on your accounts receivable and inventory to confirm asset values as well as the reliability of the reports you provide to the bank. This due diligence is called a “collateral exam” or “field audit”, and involves the bank sending an auditor to the company’s offices to review books and records to:

(1) Ensure that the company-generated reports for accounts receivable (your accounts receivable aging) and inventory are accurate and reliable

(2) Determine and confirm the amounts of any “ineligibles” within these asset classes.

In general, ineligibles are amounts that the bank will not lend against. This includes the following:

  • A/R over 90 days past due
  • Accounts that are due from foreign counter-parties
  • Accounts that are due from counter-parties that are related by common ownership to your company

In the case of inventory, ineligibles will generally include any work-in-process inventory, any consignment inventory, and inventory that is in-transit or otherwise not on your company’s premises.

Importance of Capital to Banks

When it comes to capital, the bank is essentially looking for the owner of the company to have sufficient equity in the company. Capital is important to the bank for two reasons…

First, having sufficient equity in the company provides a cushion to withstand a blip in the company’s ability to generate cash flow. For example, if the company were to become unprofitable, then it would burn through cash to fund operations. The bank is never interested in lending money to fund a company’s losses, so they want to be sure that there is enough equity in the company to weather a storm and to rehabilitate itself. Without sufficient capital, the company could run out of cash. Then they would be forced to file for bankruptcy protection.

Secondly, when it comes to capital, the bank is looking for the owner to have sufficient “skin in the game”. The bank wants the owner to be sufficiently invested in the company such that if things were to go wrong, the owner would be motivated to stick by the company and work with the bank during a turnaround. If the owner simply handed over the keys to the business, then the bank would have fewer, less viable options to obtain repayment of the loan.

Debt to Equity Ratios

There is no precise measure or amount of “enough capital”, but rather it is specific to the situation and the owner’s financial profile. Commonly, the bank will look at the owner’s investment in the company relative to their total net worth, and they will compare the amount of the loan to the amount of equity in the company – the company’s Debt to Equity Ratio. This is a measure of the company’s total liabilities to shareholder’s equity.

Remember, banks typically like to see Debt to Equity Ratios no higher than 2 to 3 times.

Conditions

Another key factor in the 5 Cs of credit is the overall environment that the company is operating in. The banker assesses the conditions surrounding your company and its industry. They determine the key risks facing your company. They also determine whether these risks are sufficiently mitigated. Even if the company’s historical financial performance is strong, the bank wants to be sure of the future viability of the company. The bank won’t make a loan if your company is threatened by some unmitigated risk not sufficiently addressed. In this assessment, the banker is going to look to things such as the following:

The Competitive Landscape of Your Company

Who is your competition? How do you differentiate yourself from the competition? How does the access to capital of your company compare to the competition and how are any risks posed by this mitigated? Are there technological risks posed by your competition? Are you in a commodity business? If so, what mitigates the risk of your customers going to your competition?

The Nature of Your Customer Relationships

Are there any significant customer concentrations (do any of your customers represent more than 10% of the company’s revenues?) If so, how does the company protect these customer relationships? What is the company doing to diversify its revenue base? What is the longevity of customer relationships? Are any major customers subject to financial duress? Is the company sufficiently capitalized to withstand a sizable write-down if they can’t collect their receivable to a bankrupt customer?

Supply Risks

Is the company subject to supply disruptions from a key supplier? How do they mitigate any risk? What is the nature of relationships with key suppliers?

Industry Issues

Are there any macro-economic or political factors affecting, or potentially affecting the company? Could the passage of pending legislation impair the industry or company’s economics? Are there any trends emerging among customers or suppliers that in the future will negatively impact operations?

Drivers of Business

The banker will need your help to identify and understand these key risks and mitigants, so be prepared to articulate what you see as the primary threats to your business, and how and why you are comfortable with the presence of these risks, and what you are doing to protect the company. The banker will need to understand the drivers of your business, which is equally as important to the banker as understanding the company’s financial profile.

Character

While we have left “Character” for last, it is not the least important of the 5 Cs of credit. Arguably it is the most important. Character gets to the issue of people – are the owner and management of the company honorable people when it comes to meeting their obligations? Without scoring high marks for character, the banker will not approve your loan.

How does a banker assess character?

Character is an intangible. It is partly fact-based and partly “gut feeling”. The fact-based assessment involves a review of credit reports on the company, and in the case of smaller companies, the personal credit report of the owner as well. The bank will also communicate with your current and former bankers. They want to determine how you have handled your banking arrangements in the past. The bank may also communicate with your customers and vendors. This is to assess how you have dealt with these business partners in the past. They will determine the soft side of character assessment by how you deal with the banker during the application process. Thus, their resultant “gut feeling” will be a determining factor.

Bankers Want to Deal With Trustworthy People

In the end, bankers want to deal only with people that they can trust to act in good faith at all times – in good times and in bad. Banks want to know that if things go wrong, that you will be there. They want to know that you will do your best. In addition, they want to ensure that the company honors its commitments to the bank. Even if the company’s financial profile is strong and scored well in all of the other 5 Cs of credit, the banker will reject the loan if they fail the character test. To be clear – it is not necessarily an issue if your company has gone through troubled times in the past. What is more important is how you dealt with the situation.

Were you forthright and proactive with the bank in communicating problems?

Or did you wait until a default situation was already in effect before reaching out to the bank?

Were you cooperative with the bank while getting through the distressed period?

We cannot stress enough the importance of character.

Five Cs of Credit Management

To summarize, the 5 Cs of credit forms the basis of your banker’s analysis as they are considering your request for a loan. The banker needs to be sure that (1) your company generates enough CASH FLOW to service the requested debt, (2) there is sufficient COLLATERAL to cover the amount of the loan as a secondary source of repayment should the company fail, (3) there is enough CAPITAL in the company to weather a storm and to ensure the owner’s commitment to the company, (4) the CONDITIONS surrounding your business do not pose any significant unmitigated risks, and (5) the owners and management of the company are of sound CHARACTER, people that can be trusted to honor their commitments in good times and bad.

Hopefully, this article has succeeded in helping you understand where your banker is coming from. With a better understanding of how your banker is going to view and assess your company’s creditworthiness, you will be better prepared to deliver information and position your company to obtain the loan that it needs to grow and thrive. You should use these 5 Cs as a credit management tool to run your company. To improve your cash flow, download the free 25 Ways to Improve Cash Flow whitepaper.

5 Cs of credit, 5 Cs of Banking

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