Financial restructuring is a specialist initiative undertaken to reorganize the financial assets and liabilities of a business enterprise in order to make the most beneficial environment for that entity. Primarily, it comprises of reorganising share capital and debt. With inefficient restructuring, companies are often entitled to favourably change their contractual relationships with lenders, shareholders and other stakeholders. It Is a type of corporate action that looks to modify the debt operations and structure of a company, with the ultimate goal of limiting financial harm besides and empower it to tap more business opportunities. Company has to carefully balance between its debt and equity and these two factors are influenced by the business condition. Need may arise for the management to undertake financial restructuring in following circumstances:
- Inability to meet current commitments
- Under-utilisation of existing production capacity
- Injecting more capital for meeting demands from customers
- Restriction on obtaining further credits from supplier / other parties
Process of financial restructuring is sometimes correlated with corporate restructuring. In case of corporate restructuring the company’s general function and composition is likely to have an effect but financial restructuring is more to do with the company’s financial health. Generally financial restructuring is required when a company’s performance is unable to keep pace with its financial obligations towards various stakeholders including creditors.
Steps involved in financial restructuring
- Detailed assessment of short-term & long-term cash requirements for a company and make sure that business will reach its critical competencies.
- All relevant stakeholders need to be immediately identified and mapped into various categories so that they accord their approval to move to next step for financial restructuring. It will protect value and avoid risk of possible insolvency for the company.
- Stakeholders may plan to challenge underlying assumptions which includes understanding the reasons for underperformance, which might involve interaction with the management team to devise suitable strategies, initiatives and the company’s business plan.
- Company should develop more than one plan to address possible contingencies. The first phase of appraisal, assessment and negotiation should lay a foundation for the development of the financial restructuring.
- Financial restructuring proposal should be prepared considering efficient processes, preserving value and tax efficiency.
- Change in economic environment, new developments and demands from stakeholders may necessitate a reworking of the plan.
Types of Restructuring
A. Debt Restructuring
Debt Restructuring is an arrangement allowing companies to reduce or negotiate its outstanding debts with the approval of lenders and creditors. By way of debt restructuring, companies can avoid default or take advantage of lower interest rates, extended credit terms etc. Simply it refers to the reallocation of resources by way of changing the terms of the debt. Following are important types:
Normal Debt Restructuring
In this process, a relatively healthy company refinances / swaps its high-interest rate debts into low-interest debt or revise repayment schedule suiting their business. The company can also swap their multiple debts having higher- interest cost and variable repayment terms into a single debt with better interest and repayment terms. In this case. funds previously used to pay off higher interest cost of debt can now be used to pay more towards the loan principal. It is a tool minimize the cost of capital while improving overall financial efficiency of the company.
2. Stressed Debt Restructuring
Debt restructuring is a process wherein a company or an entity experiencing financial distress and liquidity problems, refinance its existing debt obligations in order to gain more flexibility in the short term and make their debt more manageable overall. Generally, it is a strategy for keeping the company afloat and getting a company back on track financially. Usually, in such cases an adjustment is made by lender, creditor etc. to smoothen temporary difficulties towards loan repayment faced by the company.
3. Conversion of Debt to Equity
Conversion of debt into equity is also know as ‘swap’ which is a type of financial restructuring arrangement between the company and the lenders under which the debt components of the company are converted into equity of the business. In simple words, the debt providers become owners in the business. A debt-equity swap usually happens in cases where the business is under financial stress but the lenders decide to support on analysing viability in the business model and the commitment of promoters. In case of companies, prior permission of Hon’ble National Company Law Tribunal (NCLT) is needed. NCLT may pass an order to confirm share swap on checking various parameters including valuation report provided.
Many a times, business get impact due to high leverage or events which are outside the control of the company resulting in sustainability of the business. In such cases, lenders have to decide on whether liquidating the business of the company makes more sense or conversion of debt into equity will be more beneficial to them. Also, by becoming the owners in the business, the lender can gain more benefits if business turns around positively instead of fixed interest on their debt in the ordinary course of business.
It provides businesses with the desired capital required for survival, reduces the interest cost resulting in higher free cash flow to equity and also saves the business from default. But, conversion of debt into equity results in dilution of interest of existing equity stakeholders. In case of a distressed company, lenders ask for heavy discounts in the intrinsic value to mitigate the risk.
Above are few important strategies but there are many other ways to carry out the restructuring process.
B. Equity Restructuring
Equity restructuring is the process of reorganizing the equity capital. It includes reshuffling of the shareholders capital and the reserves that are appearing in the balance sheet. Restructuring of equity involves a process of law and is a highly regulated area wherein expertise of corporate professionals is needed.
Over capitalization is a state where earnings are not sufficient to justify the fair return on the amount of securities issued which have been issued by the company whereas under capitalization is a state where the capital which is owned by the business is much less than the borrowed capital. A company is said to be under-capitalised when it is earning exceptionally higher profits as compared to other companies or the value of its assets is significantly higher than the capital raised. Restructuring can be done in both the circumstances ~ under capitalisation and over capitalisation and suitable strategies can be applied.
1. Over capitalisation:
Earnings of the company is not sufficient to justify a fair return on the amount of share Capital and debenture issued. It can also be a case wherein total owned or borrowed funds are more than fixed and current assets which shows accumulated loss on the asset side.
Restructuring by way of:
- Capital reduction
- Buy back of shares
- Loan pre-payment to bank
- Redeeming bonds / debentures
- Repayment of fixed deposit to public
- Paying surplus back shares capital to shareholders2.
2. Under capitalisation:
In case of under capitalisation, usually own capital is much lesser than the borrowed capital. Such situation arises typically when owned capital of the company is dipropionate to the scale of its operations and its business depend upon more borrowed capital
Restructuring by way of:
- Issuing convertible securities
- Restrain to additional borrowings
- Accepting deposits for shareholders
- Converting outstanding liabilities to equity
- Injecting more capital ~ IPO, FPO, PE / VC funding, etc
- Reorganizing business ~ converting firm to company, etc
Pros & Cons
Eminent Benefits of Debt Restructuring
- Lowering the interest cost
- Safeguarding of business asset
- Improving financial management
- Getting company back on track financially
Debt restructuring may not be a good idea if:
- Adequate funds are available to servicing existing debt
- Action is Initiated without proper repayment plan
- Accessing cheap source of funds is possible
- It affects key business goals adversely
Conclusion
When the appropriate course of action is agreed upon, it should be carried out promptly and smoothly to come out of the current financial issues without disturbing the business. Planning for achievable targets for the turnaround of a business, setting aside time to evaluate the impact and then being open for creative ideas are also necessary for measuring success. However, financial restructuring is a dynamic process due to which any changes in internal or external factors including economic environment can change projections in a big way.
Continuous monitoring is needed across all stages ~ planning, implementation as well as post implementation stage and thereafter, taking necessary corrective steps while considering the situation will determine the quantum of success. Financial restructuring can have long lasting impact on the business and it can yield superior returns by maximizing value for all stakeholders. Of course, there may be considerable costs associated with restructuring exercise, however, still the corporates would like to undertake such exercise in order to avail various benefits and create value for their stakeholders.
Given the ongoing economic crisis due to Covid-19, ‘Restructuring’ can certainly be an emerging area of practice for corporate and finance professionals which can provide them multiple opportunities for revival of ailing business enterprises and their growth. However, they must remember golden words by Mr Jim Rohn, a successful American entrepreneur – “You don’t get paid for the hour. You get paid for the value you bring to the hour.”
AUTHORS – CA Deep Sharma & CA Amar R. Kakaria are qualified CAs with multiple qualifications and have got over 20 years of experience each.
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