Financial Distress Balance Sheet Analysis of a Company
You are an Investment Banking Analyst at a leading firm, preparing a report on Company X, a mid-sized manufacturing company. The company has recently faced a decline in revenue due to supply chain disruptions and increasing raw material costs. Investors are concerned about its financial stability, and your team has been tasked with evaluating its balance sheet to determine if it is in financial distress.
The following is Company X’s most recent balance sheet:
Task 1: Liquidity & Short-Term Solvency Analysis
Task: Calculate the following liquidity ratios to determine if Company X has enough short-term assets to cover its liabilities.
- Current Ratio: Compare total current assets to total current liabilities.
- Quick Ratio: Excludes inventory and only considers the most liquid assets.
💡 Hint: Current Ratio Formula
Current Ratio = (Cash + Accounts Receivable + Inventory) ÷ (Accounts Payable + Short-Term Debt)
💡 Hint: Quick Ratio Formula
Quick Ratio = (Cash + Accounts Receivable) ÷ (Accounts Payable + Short-Term Debt)
Task 2: Debt & Leverage Analysis
Task: Analyze how much financial risk Company X is taking on by calculating:
- Debt-to-Equity Ratio: Measures financial leverage.
- Interest Coverage Ratio: Indicates if the company can cover its interest payments.
💡 Hint: Debt-to-Equity Ratio Formula
Debt-to-Equity Ratio = Total Liabilities ÷ Shareholders' Equity
💡 Hint: Interest Coverage Ratio Formula
Interest Coverage Ratio = EBIT ÷ Interest Expense
Task 3: Bankruptcy Risk: Altman Z-Score
Task: Compute the Altman Z-Score to assess the probability of bankruptcy.
The formula is:
💡 Hint: Altman Z-Score Formula
Z = 1.2(A) + 1.4(B) + 3.3(C) + 0.6(D) + 1.0(E)
- A = Working Capital / Total Assets
- B = Retained Earnings / Total Assets
- C = EBIT / Total Assets
- D = Market Value of Equity / Total Liabilities
- E = Revenue / Total Assets
Task 4: Strategic Recommendations
Task: Based on your calculations, propose solutions to improve the company’s financial stability.
- Should Company X restructure its debt? If yes, how?
- Would selling non-core assets improve liquidity?
- Should the company raise funds through equity issuance?
- Can cost-cutting measures help without damaging the business?
Solution
Financial Distress Analysis – Solutions
Financial distress occurs when a company struggles to meet its financial obligations due to declining revenues, high debt levels, or poor liquidity. This solution provides a structured analysis of Company X's financial health, covering liquidity, leverage, and bankruptcy risk. The objective is to determine whether the company is at risk and to propose viable strategic solutions.
1. Liquidity & Short-Term Solvency Analysis
Liquidity ratios are essential indicators of a company's ability to cover short-term obligations. A company with poor liquidity may face operational challenges, such as delayed supplier payments, difficulty securing loans, or an inability to cover payroll expenses.
1.1 Current Ratio Calculation
The current ratio measures the company's ability to pay its short-term liabilities using its short-term assets.
Show formula
Current Ratio Formula:
Current Ratio = (Cash + Accounts Receivable + Inventory) ÷ (Accounts Payable + Short-Term Debt)
Calculation:
Current Ratio = (15,000 + 50,000 + 40,000) ÷ (40,000 + 30,000) = 1.5
Interpretation: A current ratio of 1.5 suggests that the company has some ability to cover its short-term obligations but is not in a strong position. Typically, a ratio above 2.0 is preferred for financial stability.
1.2 Quick Ratio Calculation
The quick ratio is a stricter measure of liquidity, excluding inventory, as it may not be easily converted to cash.
Show formula
Quick Ratio Formula:
Quick Ratio = (Cash + Accounts Receivable) ÷ (Accounts Payable + Short-Term Debt)
Calculation:
Quick Ratio = (15,000 + 50,000) ÷ 70,000 = 0.93
Interpretation: Since the ratio is below 1.0, the company may struggle to cover its immediate liabilities without selling inventory or obtaining external financing.
1.3 Recommended Actions
To improve liquidity, the company should consider the following measures:
- Improved cash flow management: Offer discounts for early payments and optimize accounts receivable collection.
- Short-term financing options: Secure a credit line or renegotiate supplier terms to extend payables.
- Inventory optimization: Reduce slow-moving inventory and enhance supply chain efficiency.
2. Debt & Leverage Analysis
Excessive debt increases financial risk, making a company vulnerable to economic downturns or interest rate fluctuations. Debt analysis helps assess whether a company can sustain its borrowing levels.
2.1 Debt-to-Equity Ratio Calculation
The debt-to-equity ratio measures how much debt the company has relative to shareholders’ equity.
Show formula
Debt-to-Equity Ratio Formula:
Debt-to-Equity Ratio = Total Liabilities ÷ Shareholders' Equity
Calculation:
Debt-to-Equity Ratio = 170,000 ÷ 55,000 = 3.1
Interpretation: A ratio above 2.0 is considered high, and a value of 3.1 indicates that the company is highly leveraged, increasing financial risk.
2.2 Interest Coverage Ratio Calculation
The interest coverage ratio assesses whether a company generates sufficient earnings to cover its interest obligations.
Show formula
Interest Coverage Ratio Formula:
Interest Coverage Ratio = EBIT ÷ Interest Expense
Calculation:
Interest Coverage Ratio = 12,000 ÷ 8,000 = 1.5
Interpretation: A ratio below 2.0 indicates a potential risk, as earnings may not be sufficient to cover interest payments comfortably.
2.3 Recommended Actions
To reduce financial risk, the company should consider:
- Debt restructuring: Negotiate lower interest rates or extend loan maturities.
- Equity financing: Issue additional shares to strengthen capital structure.
- Cost optimization: Reduce discretionary expenses and streamline operations.
3. Bankruptcy Risk: Altman Z-Score
The Altman Z-Score is a widely used model to assess the likelihood of bankruptcy. A score below 1.81 suggests high financial distress.
3.1 Z-Score Calculation
Show formula
Z = 1.2(A) + 1.4(B) + 3.3(C) + 0.6(D) + 1.0(E)
- A = Working Capital / Total Assets = (105,000 - 70,000) ÷ 225,000 = 0.155
- B = Retained Earnings / Total Assets = 35,000 ÷ 225,000 = 0.156
- C = EBIT / Total Assets = 12,000 ÷ 225,000 = 0.053
- D = Market Value of Equity / Total Liabilities = 60,000 ÷ 170,000 = 0.353
- E = Revenue / Total Assets = 150,000 ÷ 225,000 = 0.667
Calculated Z-Score: 1.46
Interpretation: Since the Z-Score is below 1.81, Company X is in the high-risk category for potential bankruptcy.
3.2 Recommended Actions
- Financial restructuring: Sell non-core assets to reduce debt.
- Revenue growth strategies: Expand product offerings or enter new markets.
- Operational efficiency: Reduce costs and improve productivity through automation.
4. Strategic Recommendations
Based on the analysis, the following strategies are recommended to improve financial stability:
Short-Term (0-6 months)
- Secure immediate liquidity through working capital management.
- Negotiate supplier payment extensions.
Medium-Term (6-18 months)
- Restructure high-interest debt to reduce financial pressure.
- Optimize cost structures without sacrificing growth.
Long-Term (18+ months)
- Consider mergers or acquisitions for strategic stability.
- Strengthen financial forecasting and risk management.