Distress Symptoms and Remedies: formula sheet

Key formulas

Interest coverage ratio

Interest coverage = EBIT ÷ Interest expense

Lower is worse. Below about 1 means operating profit does not cover interest. Some use EBITDA in the numerator, so check the question.

Leverage ratio

Debt ÷ EBITDA

Higher means more distress risk. Lenders often set a maximum in covenants.

Debt-to-equity

Total debt ÷ Shareholders' equity

A rising ratio signals heavier reliance on debt, whether from new borrowing or equity losses.

Current ratio

Current assets ÷ Current liabilities

Below 1 suggests short-term liquidity pressure. It is a symptom, not proof of distress.

Distress vs bankruptcy rule

Distress = economic/financial condition; Bankruptcy = legal process

Distress can occur without bankruptcy, and can be resolved by workout or restructuring.

Expected cost of financial distress

Expected cost = P(distress) × Cost of distress

Cost of distress is the sum of direct and indirect costs, often expressed as a percentage of firm value.

Trade-off theory value

V(levered) = V(unlevered) + PV(tax shield) − PV(expected distress costs)

Optimal debt is where the marginal benefit of the tax shield equals the marginal expected distress cost.

Total distress costs

Total costs = Direct costs + Indirect costs

Direct: legal and administrative. Indirect: lost sales, fire-sale losses, underinvestment.

Fire-sale loss

Loss = Fair value − Sale proceeds

Measured against fair value, not book value.

Perpetual tax shield (constant debt)

PV(tax shield) = Tax rate × Debt

Applies when debt is permanent and constant; the debt is assumed to be riskless in this simple case.

Creditor's comparison rule

Accept if value of new package ≥ expected recovery in bankruptcy (net of delay and costs)

A rational creditor compares the offer with the bankruptcy alternative, not with face value.

Haircut

Haircut = (Old face value − Value of new package) ÷ Old face value

Measures the loss the creditor takes in the exchange.

Holdout payoff logic

Holdout payoff > Participant payoff, if enough others accept

The holdout keeps its full claim in a healthier firm. This is the free-rider incentive.

Workout value condition

Workout is feasible only if Value of restructured firm − Workout costs > Value in bankruptcy − Bankruptcy costs

Savings in costs must be shared so every key party prefers the deal.

Absolute priority rule

Secured → administrative and priority claims → senior unsecured → junior/subordinated → equity

Each class must be paid in full before a lower class receives value. Secured claims are covered only up to collateral value; any shortfall becomes an unsecured claim. Administrative costs and DIP superpriority claims sit ahead of prepetition unsecured claims.

Recovery rate for a class

Recovery % = Value distributed to class ÷ Face amount of class claims

Use when the available value is less than total claims. Fill classes in order of priority.

Secured claim shortfall

Deficiency claim = Claim − Collateral value (if Claim > Collateral value)

The deficiency ranks as a general unsecured claim.

Chapter 7 vs Chapter 11 test

Liquidation: assets sold, firm ends. Reorganization: firm continues under a plan

A plan must usually give each dissenting creditor at least what it would get in Chapter 7 (best-interests test).

Recovery rate and LGD

LGD = 1 − Recovery rate

Recovery is a percentage of face value. A 40% recovery means a 60% LGD.

Absolute priority waterfall

Recovery of class k = min(100%, max(0, Distributable value − Σ claims senior to k) ÷ Claim of class k)

Value is paid in order of seniority. Each class is paid in full before the next receives anything.

Expected recovery

E[Recovery] = Σ (probability of scenario × recovery in scenario)

Use scenarios such as reorganization and liquidation, each with its own probability.

Return on distressed purchase

Return = (Recovery value ÷ Purchase price) − 1

Both values are per unit of face value. Discount for time if the process is long.

Fulcrum security

Fulcrum = the most senior class not paid in full

It usually receives the reorganized equity and controls the outcome.

Quick revision

• Distress signs: weak interest coverage, high leverage, falling liquidity, widening credit spreads, covenant breaches.
• Direct costs: legal, administrative and advisory fees.
• Indirect costs: lost sales, lost key staff, tighter supplier terms, forced asset sales.
• Out-of-court workouts are usually faster and cheaper but need broad creditor agreement.
• Holdout creditors are a main obstacle to workouts.
• Chapter 7 is liquidation: assets are sold and proceeds distributed.
• Chapter 11 is reorganisation: the firm keeps operating under court supervision.
• Chapter 11 gives an automatic stay that pauses creditor collection.
• Absolute priority: secured and senior claims are paid before junior claims and equity.
• Recovery rate = amount recovered ÷ claim; LGD = 1 − recovery rate.
• Seniority and collateral are major drivers of recovery.
• Distressed debt investors buy troubled debt at a discount and bet on restructuring value.

Common mistakes

• Treating distress and bankruptcy as the same thing. Fix: Distress is an economic condition. Bankruptcy is a legal process. Many distressed firms restructure out of court.
• Reading a higher interest coverage ratio as a warning sign. Fix: For coverage, lower is worse. For debt ratios, higher is worse.
• Treating distress costs as arising only after bankruptcy filing. Fix: Remember that indirect costs begin once default becomes likely, well before any filing.
• Assuming direct costs are the largest component. Fix: Indirect costs are usually harder to measure and often larger. Do not claim direct costs dominate.
• Saying an out-of-court deal legally binds all creditors. Fix: A workout binds only those who agree. Binding dissenters needs bankruptcy or a contractual majority-vote clause.
• Describing the holdout problem as a creditor being unable to find the firm. Fix: It is a free-rider incentive: a creditor refuses to concede because it benefits from others' concessions.
• Saying Chapter 11 always ends in liquidation or that Chapter 7 allows continued operation. Fix: Remember: 7 = sell and end, 11 = restructure and continue. A Chapter 11 plan can include a sale, but the default purpose is reorganization.
• Thinking the automatic stay protects secured creditors fully or is permanent. Fix: The stay halts collection, but a secured creditor may seek court relief if its collateral is not adequately protected. It lasts while the case runs, subject to the court.
• Treating all debt as having the same recovery rate Fix: Always rank the claims first. Recovery depends on the class, not just on the firm.
• Dividing value equally among creditors Fix: Apply absolute priority across classes. Share pro rata only among claims of the same rank.

Exam tips

• Expect case-style questions that mix operating, financing and macro causes. Label each fact before answering.
• Know the direction of every ratio: coverage falling is bad, leverage rising is bad.
• Watch for distractor options that equate distress with bankruptcy or a breach with default through filing.
• Check whether the question uses EBIT or EBITDA for coverage before calculating.
• Rating downgrades, spread widening and covenant breaches are signals. Pick answers that treat them as symptoms, not root causes.
• Expect scenario stems asking you to label a cost as direct or indirect. Learn the lists.
• Debt overhang questions usually involve a positive-NPV project rejected; confirm who gets the benefit.
• In trade-off questions, link higher volatility or intangible assets to lower optimal leverage.