Introduction to Corporate Finance

22: Insolvency and Financial Distress

LEARNING OBJECTIVES

After studying this chapter, you should be able to:

describe and differentiate between

business failure, insolvency, financial

distress and bankruptcy, and discuss why

companies may seek insolvency

explain how companies in Australia

undertake the process of appointing an

administrator and what that role entails

describe the alternatives that are available

to companies that find themselves in

financial distress

review the tools used by many analysts

in attempts to predict the occurrence of

insolvency.

LO 22.4

A business failure or insolvency is an unfortunate

outcome. Although the majority of companies

that fail do so within the first few years of their

lives, other companies grow, mature and then fail

much later. The failure of a business can be viewed

in a number of ways, and can result from many

different causes. The impact of the insolvency on

the company tends to depend on its cause, and in

this chapter we will examine the alternatives that a

company in Australia may follow if it is heading into

failure.

Insolvency is a term that can apply to either

an individual or a business, but is more often used

in relation to a business or company (bankruptcy

usually refers to a person). A business is said to be

insolvent when it cannot pay its debts when they

are due. It is an offence under Australian law if the

directors continue to operate and incur more debts

when a company is insolvent.

If a company is facing financial difficulties and

the directors or creditors believe that it is, or may

become, insolvent, it may end up in one of the

following types of formal administration:

• liquidation, also known as winding up


• voluntary administration or deed of company
  arrangement


• receivership.

The principal law regulating corporate

insolvency in Australia is the Corporations Act 2001

and subsequent amendments. The Bankruptcy Act

1996 regulates personal bankruptcy.

business failure

A company’s inability to stay

in business

Corporations Act 2001

The Commonwealth Act

regulating, among other

matters, corporate insolvency

in Australia

22-1 INSOLVENCY AND BUSINESS FAILURE

A headline blares that a company has filed for liquidation or has ‘gone into receivership’. The words

themselves signify failure, but they do not describe how the company failed. Is the company insolvent in

the sense that its liabilities exceed its assets? Or does the company have a liquidity problem and is unable

to pay its debts? Perhaps the filing is the result of both of these factors, or of other factors entirely.

As a working definition, financial distress occurs when a company’s cash flows are insufficient to pay its

current obligations. Although a company usually becomes insolvent because its finances are distressed, the

term insolvent does not really describe a financial condition. Instead, insolvency refers to a legal process.

Typically, companies that become insolvent have been in financial distress. As noted in the discussion

of capital structure in Chapter 13, the threat of insolvency frequently discourages the use of debt

financing. The costs associated with the threat of insolvency can lower the value of a levered company

below its unlevered value in spite of the tax benefits that accompany debt financing. So the costs

LO 22.1

insolvent

The situation in which a

company’s liabilities exceed

its assets and is unable to pay

its debts when they are due

financial distress

The situation in which a

company’s cash flows are

insufficient to pay its current

obligations

insolvency

Occurs only when a company

enters the condition formally

and effectively surrenders

control of the company to an

external administrator. It is

a legal process rather than a

financial condition

LO 22.1 LO 22.3

LO 22.2