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ACCA Strategic Professional · Advanced Financial Management · Financial reconstruction

Which of the following is the most direct indicator that a company is in financial distress and may need a financial reconstruction rather than a simple refinancing?

Interest cover below one, debt that cannot be repaid from operating cash flows and breached covenants are the strongest signs of distress. They show the capital structure is unsustainable, so a reconstruction may be needed. A share price fall, a dividend cut or high gearing alone are not conclusive.

  1. AIts share price has fallen by 10% over a year while profits remain positive
  2. BIts interest cover is below one and it cannot meet debt repayments from operating cash flows, with breached covenantsCorrect
  3. CIt has declared a lower dividend than the previous year
  4. DIts gearing ratio is above the industry average but cash flows are stable

Explanation

Distress is shown by inability to service debt from operations together with covenant breaches, which suggests the capital structure is unsustainable. A modest share price fall, a dividend cut or above-average gearing with stable cash flow do not by themselves show that the structure is unworkable.

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