In Search of Insolvency Clues

Muscling their way through several years of challenging economic conditions, capital markets have learned a great deal about the importance of risk management, but there's still no silver bullet for identifying and heading off bankruptcy.

“It's a really muddled area,” says J.B. Heaton, a partner with the Chicago law firm of Bartlit Beck Herman Palenchar & Scott. Through litigation, bankruptcy experts have a good sense for how courts will dissect a failed company after the fact, he says. “But it's not like there is one clear answer. It's like appraising a house; there can be a lot of subjectivity to it.”

Investors have demanded better warning signs for insolvency recently, and the Financial Accounting Standards Board has been working on identifying ways to require companies to send up a red flag when concerns about being able to continue as a going concern arise. But given the stakes for companies, and the potential for insolvency warnings to be self-fulfilling, the task is a complex one.

Solvency is difficult to precisely identify because the indicators can vary dramatically for different kinds of companies, says Esther DuVal, managing director at CBIZ Corporate Recovery Services. “Solvency is defined as net asset value—do you have the ability to pay down your debts as they come due?” she says. “But you have to be mindful of the context. Everyone wants to know what the magic warning sign is, but I can't say there's a single one. You have to look cumulatively at what's going on with the company.” Plenty of service and retail businesses, for example, show big swings in traditional solvency indicators, but they are subject to seasonality.

Brian Markley, a partner at advisory firm SolomonEdwards, says he's partial to analyzing the cash flow statement to look for signs of trouble. He looks at metrics like free cash flow, accounts payable, and accounts receivable for important clues. If a company is generating cash by not paying its bills, is not collecting adequately from customers, or is reducing its capital investments, those could be troubling indicators. “As I work through the cash flow statement, if I have three to five or six tick marks next to things that individually might be a red flag, those little red flags become much more of an alert,” he says.

In bankruptcy proceedings, courts generally test a company's solvency by looking at three specific questions, says Heaton. From a cash flow perspective, was there reason to believe the company could expect to pay its debts as they came due? Looking at the balance sheet, did the face value of liabilities exceed the fair value of assets? And did the company generally have enough capital? Heaton says the tests are easy to name, but not as easy to perform. Bankruptcy courts use the tests to help determine if companies made payments in its final thrust to collapse what should be recaptured and paid to entitled creditors instead.

DuVal says additional indicators can be less obvious but equally telling: sudden changes in leadership, elimination or reductions in dividends, or the creation of ad hoc groups, like landlords or trade creditors. For public companies, however, Heaton believes there's an additional indicator that is often underappreciated—market pricing of a company's debt and securities. If the market is trading a company's debt or securities in a way that suggests they don't expect the company to provide full recovery to creditors, that's a powerful market indicator, he says. “There can be a tendency for public companies to not have faith in the market, especially when it's low,” he says. “It's probably the best, underutilized way of not getting caught unaware.”

Peter Bible, a partner with audit firm EisnerAmper, says auditors often rely on a test called the Altman Z-Score, developed by New York University professor Edward Altman in the late 1960s and updated in 2012. Altman developed a mathematical equation to factor a company's assets and liabilities with its working capital, retain earnings, earnings before interest and tax, market value of equity, and sales to arrive at a score. The lower the score, the greater the likelihood of bankruptcy. “It is remarkably accurate at predicting bankruptcies one year before the event,” he says.

“Everyone wants to know what the magic warning sign is, but I can't say there's a single warning sign. You have to look cumulatively at what's going on with the company.”

—Esther DuVal,

Managing Director,

CBIZ Corporate Recovery Services

As an auditor, Bible appreciates the ability of the score to predict the company's likelihood of seeking protection from creditors in a Chapter 11 bankruptcy filing, but the score does not predict the likelihood of liquidation. That puts auditors in a difficult position when it comes to raising the red flag that a company might not have what it takes to remain a going concern, which is one of the auditor's duties under auditing standards.

“I can name a lot of companies that operate under the protection of bankruptcy courts—major airlines and major retailers that have been there several times,” he says. It doesn't necessarily mean they are in danger of going out of business, he says. Still, corporate collapses in recent years that weren't foretold in financial statements or flagged by auditors have put pressure on auditors to raise the going-concern flag even when companies file for Chapter 11. “This is something that's very misunderstood,” he says. “It's a huge misconception that if you file for Chapter 11 the going-concern qualification is imminent. It's what the world has come to expect, so now that's what we do.”

FASB's Conundrum

FASB has spent years wrestling with how to get a standard into accounting literature that would direct management to provide some early warning to investors that the company may be headed for trouble. The board first proposed the idea in 2008 and is expected soon to publish a new attempt.

The murkiness of defining solvency and identifying the tipping point into insolvency has made the task difficult. “The worst looking set of financial statements can be in risk of bankruptcy, but the company could still be a going concern,” says Chuck Mulford, accounting professor at Georgia Tech and director of its Financial Analysis Lab. The classic concern about creating a self-fulfilling prophesy has further complicated FASB's job, he says. “It's very frightful language. Just saying it can bring it about.” More recently, FASB issued new guidance on when management would be required to reflect the imminence of liquidation by switching to a liquidation basis of accounting, and Bible believes it will go a long way toward bringing clarity to the issues.

Business and Non-Business Filings

Years Ended June 30, 2008-2012

According to the USCourts.gov table below, the majority of bankruptcy filings involve predominantly non-business debts. For the 12-month period ending June 30, 2012, non-business filings—where the debts are predominantly personal or consumer in nature—totaled 1,267,167, down 14 percent from the 1,477,426 non-business bankruptcies filed in the 12-month period ending June 30, 2011.

Year

Total

Non-Business

Business

2012

1,311,602

1,267,167

44,435

2011

1,529,560

1,477,426

52,134

2010

1,572,597

1,512,989

59,608

2009

1,306,315

1,251,294

55,021

2008

967,831

934,009

33,822

Source: USCourts.gov.

The insurance sector has made some headway into pinpointing and addressing concerns around insolvency in recent years, says Shawn Seasongood, a managing director at consulting firm Protiviti. The National Association of Insurance Commissioners instituted the Solvency Modernization Initiative in 2008 to establish a new regulatory framework for insolvency. It takes into account capital requirements, accounting rules, insurance valuation, reinsurance, and group regulatory issues.

Where insurers have struggled with insolvency in the past several decades, the root cause is usually some unseen, unpredicted event, not necessarily the expected problems of under-reserving, rapid growth, or credit risk, says Seasongood. That led sector leaders to focus on enterprise-level issues, which the SIM was meant to address. Insurers will face their first required filings in 2015 to explain quantitatively and qualitatively their risk management across the enterprise. “It's a work in progress,” he says.