Page 38 - Bankruptcy and Reorganization Services

significant bankruptcy predictors. fn 2 As indicated previously, the Altman Z-Score model is an account-
ing-based model that can be applied to private as well as public companies. The Ohlson O-Score model
is another accounting-based model that, according to some studies, is a better forecaster of bankruptcy
than the Altman Z-Score.

Other bankruptcy risk models employ accounting data as well as market data. As a result, such models
can only be employed with public companies. One such model was originally developed by Robert Mer-
ton and is generally referred to as the distance-to-default method for predicting bankruptcy. fn 3 Another
model was developed by John Campbell, Jens Hilscher, and Jan Szilagyi. fn 4 Both the Merton model
and the Campbell, Hilscher, Szilagyi model are better predictors of bankruptcy than the accounting-
based models referenced in the preceding paragraph.

Statements of Cash Flows

One often overlooked tool is an analysis of the statement of cash flows in order to understand the
sources and uses of cash flows generated by the debtor. When sufficient information is available, it is al-
so useful to compare this information with information about the debtor’s industry peers to gain further
insight into whether the debtor was operating in a business-as-usual manner at the valuation date. Be-
cause these statements break down the debtor’s cash flows into operating, investing, and financing activ-
ities, they highlight where cash was coming from and how it was being used. For instance, if the debt-
or’s operating and investing activities were consistently using cash (for instance, as a result of funding
operating losses, increases in receivables and inventory, or purchases of fixed assets) and this cash was
being financed through debt advances and equity contributions, this might be highly relevant infor-
mation, especially if the debtor was not in a position to continue this practice indefinitely. Such an anal-
ysis can be a useful tool to clearly and succinctly illustrate the debtor’s sources and uses of cash flows to
the various parties and the court.

Understanding the Debtor and Its Environment

A good valuation requires the valuation analyst to have a strong understanding of the subject company.
Not surprisingly, bankruptcy courts are very interested in what was happening to the debtor at the time
of the valuation, particularly if insolvency is alleged. Various tools and organizing concepts are availa-
ble to help valuation analysts gain an understanding of a debtor’s internal and external conditions. De-
pending on the facts and circumstances and particularly upon available information, in addition to finan-
cial ratios and benchmarking, the following concepts may be helpful to analysts: SWOT, economic life
cycle (introduction, growth, maturity, decline), franchise versus commodity (pricing power versus ge-
neric products and services), market and industry analysis, and competitive advantage (intellectual prop-
erty, barriers to entry). fn 5

fn 2 Tyler Shumway, "Forecasting Bankruptcy More Accurately: A Simple Hazard Model," The Journal of Business 74, no. 1 (2001):
101–24.

fn 3 R. C. Merton, "On The Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance 29 (1974): 449–470.

fn 4 J. Y. Campbell, J. Hilscher, and J. Szilagyi, "In Search of Distress Risk," Journal of Finance 63 (2008): 2899–2939.

fn 5 John A. Pearce and Richard Robinson, Formulation, Implementation and Control of Competitive Strategy, 8th ed. (New York:
McGraw-Hill Irwin, 2003).

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