Financial reconstruction: formula sheet

Key formulas

Interest cover

Interest cover = PBIT ÷ interest expense

Low or falling cover warns that profits may not support debt. Below about 1 means profit does not cover interest; there is no universal safe level, so compare with the sector.

Gearing

Gearing = debt ÷ equity, or debt ÷ (debt + equity)

State which version you use. Rising gearing increases fixed claims on cash flow.

Current ratio

Current ratio = current assets ÷ current liabilities

Below 1 suggests short-term liquidity strain, but some sectors run low ratios safely.

Quick ratio

Quick ratio = (current assets − inventory) ÷ current liabilities

Stricter than the current ratio because inventory may not convert to cash quickly.

Reconstruction test

Going-concern value > liquidation value, and each party receives at least its liquidation outcome

This is the core logic. Check it for every class of claimant before recommending a scheme.

Liquidation priority

Costs of liquidation, then secured creditors (from their security), then unsecured creditors, then shareholders

Exact ranking depends on local insolvency law. Use the order given in the question.

Order of claims in liquidation

Fixed charge holders (from their fixed charge assets) → liquidation costs and preferential creditors → floating charge holders → unsecured creditors (pro rata) → shareholders

Use this to find each party's walk-away value. Fixed charge holders are paid from the assets under their charge first. Floating charge holders rank after costs and preferential claims. Follow the priority order stated in the question; do not assume a different ranking.

Recovery rate for unsecured claims

Recovery % = Funds available for unsecured creditors ÷ Total unsecured claims × 100

Funds available include any surplus on secured assets after the secured lender is paid in full. Apply the same percentage to all unsecured claims of equal rank.

Value to a party under the scheme

Value = New debt received (at value) + Cash received + Percentage of new equity × Post-scheme equity value

Post-scheme equity value = going concern value of the business − post-scheme debt. The question normally gives the going concern value or a way to estimate it.

Acceptance test

Value under scheme ≥ Value in liquidation (for each party)

A party that is no better off has no reason to agree, so aim for a clear gain. Shareholders only need a positive value because their liquidation value is nil.

Minimum equity stake for a lender

Minimum % = (Liquidation recovery − New debt and cash received) ÷ Post-scheme equity value

This gives the lowest offer a lender would accept. In practice, add a premium for the extra risk.

Liquidation order of payment

Secured claims (from their security) → liquidation costs and preferential claims → unsecured claims → shareholders

Any secured shortfall becomes an unsecured claim. Follow the order the question gives. Use the legal ranking in the question and do not assume your own.

Recovery rate for unsecured creditors

Recovery rate = cash available to unsecured ÷ total unsecured claims

Total unsecured claims include trade creditors and the unsecured shortfall of secured lenders. Cash available is after liquidation costs and after secured claims are paid from their security.

Value of a party's package under the scheme

Value = face value of new debt + (number of new shares × value per share)

Use the share value given. If only total equity value is given, a party's share = its percentage holding × equity value.

Gain or loss versus the alternative

Gain/(loss) = value under scheme − value under liquidation (or no action)

A party that is worse off is unlikely to agree unless the scheme is changed. Calculate this for every party.

Balance check for the pro forma statement of financial position

Total assets − total liabilities = share capital + reserves

Write-offs of debt create gains that raise equity. Asset write-downs reduce equity. New cash raises both assets and equity.

Liquidation test for each creditor or shareholder

Alternative is acceptable if payout under alternative ≥ payout in liquidation

Rational parties accept a scheme only if they are no worse off than in liquidation. Often they need to be clearly better off.

Distribution in liquidation

Net proceeds → liquidation costs → secured creditors (from their assets) → preferential creditors → unsecured creditors → shareholders

Exact ranking varies by jurisdiction. Apply the order given in the question. Shareholders receive only what is left.

Recovery rate

Recovery per ₹1 owed = amount received ÷ amount owed

Use it to compare creditor classes under different options.

Value of going concern vs break-up

Benefit of rescue = going-concern value − break-up value

If this is positive, there is value to share between parties, which justifies trying a rescue.

Quick revision

• Reconstruction suits a business that is viable but has a broken capital structure or short-term cash problem.
• Typical causes: falling sales, high gearing, poor cash management, overtrading and weak management.
• Tools include debt-for-equity swaps, lower interest, longer maturities, write-offs and new finance.
• Each party accepts only if it expects to be better off than in the alternative, usually liquidation.
• In liquidation, secured creditors are paid from their security first, then unsecured creditors, then shareholders from any surplus.
• Shareholders usually accept dilution because liquidation would often give them nothing.
• Compute each party's liquidation receipt, then its scheme receipt, then compare.
• Check that post-scheme cash flows can service the new debt and that gearing is sustainable.
• New investors need an acceptable return for the risk they take, or they will not supply finance.
• Compare the scheme with administration and liquidation before recommending.
• Always give a recommendation, state the key risks and show which parties may need persuading.
• Link your commentary to the scenario facts to earn professional skills marks.

Common mistakes

• Treating distress as the same as making a loss. Fix: Always check cash flow, liquidity and debt servicing. Say that profitable firms can fail through cash shortage.
• Quoting ratios without interpretation. Fix: After each ratio, state what it means for lenders, the risk of default, and the likely action needed.
• Using book value of debt instead of realisable value in liquidation. Fix: Always start from the cash that assets would realise. Pay secured lenders from their security, then share the rest among unsecured claims.
• Ignoring any surplus on secured assets. Fix: If the security sells for more than the secured debt, the excess goes to the unsecured pool. Add it to the funds available.
• Treating a secured lender's shortfall as lost entirely. Fix: Move the shortfall into the unsecured pool. The lender then shares in the unsecured recovery rate.
• Forgetting liquidation costs. Fix: Deduct liquidation costs from the assets available to unsecured creditors before calculating the recovery rate, unless the question says otherwise.
• Treating administration and receivership as the same thing. Fix: Remember who the appointee serves. A receiver acts for the secured lender who appointed them. An administrator acts for creditors as a whole and aims to rescue or get a better result than liquidation.
• Using going-concern values when calculating liquidation receipts. Fix: Use break-up or realisable values given in the question, and deduct liquidation costs before paying creditors.

Exam tips

• Link every ratio to a consequence for lenders or shareholders. A bare number earns few marks.
• Quote evidence from the scenario for each cause of distress. Examiners reward application.
• When asked to compare reconstruction with liquidation, always show liquidation receipts per class, using the priority order given.
• Raise viability and the credibility of forecasts. This shows scepticism and commercial acumen for professional skills marks.
• Write a clear recommendation in the final lines, with one or two key risks.
• Always calculate the liquidation position first. Many marks depend on showing each party's walk-away value, and the rest of the answer builds on it.
• Present your working as a table for each party, with liquidation value, scheme value and gain or loss. It is quick to mark and easy for you to check.
• Write a short comment on each party. A calculation without a view on whether they would agree loses analysis marks.