SMEs and Family Business Conference

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Lesley Barnett
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1 New Zealand Governance Centre SMEs and Family Business Conference Detecting Insolvency David Emanuel 14 August 2009

2 Outline of presentation Solvency defined, and issues that arise from an accounting perspective. Some general issues that affect SMEs. Keeping as clear as one can from insolvency.

3 Solvency defined Companies Act 4Meaning of solvency test (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 the value of its liabilities, including contingent liabilities. The Financial Reporting Act is relevant here.

4 Reckless ess trading 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 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.

5 Accounting Principles Some things may seem strange. Here is an illustration. Balance Sheet Debt 100 Assets 300 Equity Take a high human capital investment company, so there is not much on the balance sheet. Consultancy, Biotech, IT, network company, NZRU. Say the cash flows are expected to be Say the exchange rate is expected to be USD

6 Accounting Principles So the $NZ cash flow is expected to be p a Say the required rate of return is 0.1 So the "market value" of the company is Say for ward rates equal spot rates And the company hedges five years expected CFs Initial value of the forward contract is 0

7 Accounting Principles 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 Obligation is to deliver more valuable USDs So the "market value" of the company is So the value has changed by 12.42%

8 Accounting Principles cpes However the hedge value is now negative Obligation is to deliver more valuable USDs So the "market value" of the company is So the value has changed by 12.42% But the book value (balance sheet position) is: Debt Assets Equity

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

10 Scoring Models Altman s model Matched bankrupt and non-bankrupt firms on size and 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 EBIT/TA ROA, profitability MVEQ/BVL market s assessment of profitability and risk S/TA use of assets to generate sales Z increasing => good

11 Scoring Models Ohlson s s model Ohlson used 105 bankrupt and 2,058 non- bankrupt firms y = SIZE TL/TA 1.43WC/TA CL/CA 0757CL/CA 2.37NI/TA 1.83FU/TL NIL2YR 1.72TL>TA 0.521CHNI/SUMABSNI y increasing => bad ; y = ln(p/(1-p)) P is the probability of bankruptcy.

12 What do we learn from scoring models? Not a lot from the detailed structure. Quite a lot from the variables that are on the right hand side of the equals sign. Of course, most of those variables are unsurprising. i

13 An accounting and finance take on SMEs Ability to raise (additional) capital is constrained. It is more difficult to establish value and hence easier to leave money on the table if new outside equity is raised. There are generally fewer agency issues. On average owners are less well diversified and this may have implications for required rates of return on investment decisions, and hence on the values placed on assets.

14 Keeping as clear as one can from insolvency - an accounting and finance take on SMEs Capital structure t principles. i 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. The higher h the growth options, the less the current debt levels should be. The longer the duration of the assets, the longer the 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.

15 Keeping as clear as one can from insolvency -an accounting and finance take on SMEs Risk return principles. If your business operates in more than one industry segment, look at using differing 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.

16 Expected return B A WACC risk

17 Keeping as clear as one can from insolvency - an accounting and finance take on SMEs Required returns. Most models for computing required returns assume 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.

18 Required returns 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 look at what venture capital partnerships require (and don t always get)). 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.

19 Expected return E* } Additional return E CAPM x required } Risk - volatility

20 DST Dynamic solvency techniques. These techniques are used by actuaries in the insurance 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 to use DSTs via sensitivity analysis or simulation.

21 The business model 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 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 The allocation of decision rights How performance is evaluated How people are paid

CREDIT RISK. Credit Risk. Recovery Rates 11/15/2013

CREDIT RISK. Credit Risk. Recovery Rates 11/15/2013 CREDIT RISK Credit Risk The basic credit risk equation is Credit risk = Exposure size x Probability of default x Loss given default Each of these terms is difficult to measure Each of these terms changes