Learning Outcomes
After reading this article, you will be able to identify common causes of corporate failure, evaluate key financial failure prediction models, and explain how financial covenants function as early warning systems. You will learn to use ratios to assess financial health, interpret the implications of covenant breaches, and recognise practical steps for managers in stress situations. The article is designed for direct ACCA exam preparation.
ACCA Advanced Financial Management (AFM) Syllabus
For ACCA Advanced Financial Management (AFM), you are required to understand the factors that signal potential corporate failure, how to predict financial distress using appropriate models, and the implications of covenant stress. In particular, you should focus your revision on:
- Assessing organisational performance using ratios and trends to identify financial distress
- Applying failure prediction models to evaluate going concern risks
- Understanding the role and design of financial covenants in debt agreements
- Analysing covenant breaches and their consequences for stakeholders
- Recommending strategic responses to early warning signals of business failure
Test Your Knowledge
Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.
- Which ratio is most commonly used in failure prediction models to assess insolvency risk?
- What is a financial covenant, and why do lenders include them in loan agreements?
- True or false? A single breach of a financial covenant always triggers automatic loan recall.
- List two qualitative and two quantitative indicators that may give early warning of corporate financial distress.
- Describe how the Altman Z-score is used to evaluate corporate failure risk.
Introduction
Assessing and mitigating the risk of corporate failure are essential skills for senior financial managers. Predicting distress early enables prompt corrective action and protects stakeholder value. This article reviews the main models for forecasting business failure and explains how financial covenants act as early alerts to deteriorating conditions. You will learn both theoretical and practical tools for recognising and responding to corporate decline.
Key Term: financial distress
A situation where a company is unable to meet its financial obligations as they fall due, often leading to breach of agreements, strategic crisis, or insolvency.Key Term: financial covenant
A legally binding condition in a debt agreement that requires the borrower to maintain certain financial ratios or performance standards.Key Term: failure prediction model
A quantitative approach, often using financial ratios, to estimate the likelihood that a company will experience financial failure within a specified period.
CAUSES OF CORPORATE FAILURE
Corporate failure rarely happens overnight. Most companies slide into distress due to a combination of internal and external causes.
Common causes include:
- Prolonged operating losses or declining revenues
- Ineffective management or loss of key personnel
- High debt levels and excessive financial gearing
- Over-trading and poor working capital management
- Inability to adjust to market changes or disruptive technologies
Failure to act on early warning signs increases the risk of a crisis that may become irreversible.
USING RATIOS AND TRENDS TO SPOT FINANCIAL DISTRESS
Ratio analysis provides the starting point for detecting declining financial health. Key indicators include:
- Profitability ratios (e.g., declining return on capital employed)
- Liquidity ratios (current and quick ratios, deteriorating cash position)
- Gearing ratios (rising debt/equity, falling interest cover)
- Efficiency ratios (slowing receivables turnover, high inventory holding)
- Trends over time are often more insightful than single-period values.
Qualitative factors such as management turnover, loss of major customers, or negative press coverage should also be considered.
Key Term: interest cover
The ratio of operating profit to finance charges, indicating how comfortably a firm can meet its interest obligations.
FAILURE PREDICTION MODELS
Quantitative Models
The most widely used failure prediction models combine ratios in formulae to assign a "score" representing business health or failure risk.
Altman Z-Score
A leading model, developed by Edward Altman, which weights a set of ratios to calculate a score. A lower Z-score suggests higher risk.
Formula (Classic version for manufacturing firms):
Z = 1.2 × (Working capital / Total assets) + 1.4 × (Retained earnings / Total assets) + 3.3 × (EBIT / Total assets) + 0.6 × (Market value of equity / Book value of total liabilities) + 1.0 × (Sales / Total assets)
Scoring guidance:
- Z > 2.99: "Safe" zone
- Z < 1.81: "Distress" zone
- Between: "Grey" area (some risk)
Other Models
Other models include:
- Ohlson O-Score (probability of bankruptcy using logit regression)
- Springate Model (simplified ratio-based approach)
- Taffler Model (UK-specific, uses profitability, gearing, liquidity, and working capital ratios)
All models have limits: they rely on historic data, do not capture qualitative factors, and may be less reliable in new industries or markets.
Worked Example 1.1
A listed manufacturing company presents the following year-end figures (all in $m):
- Working capital: 18
- Retained earnings: 14
- EBIT: 12
- Total assets: 60
- Market value of equity: 36
- Book value of total liabilities: 24
- Sales: 90
Calculate the Altman Z-score and interpret the result.
Answer:
Insert the values into the formula: Z = 1.2 × (18/60) + 1.4 × (14/60) + 3.3 × (12/60) + 0.6 × (36/24) + 1 × (90/60) Z = 1.2 × 0.3 + 1.4 × 0.233 + 3.3 × 0.2 + 0.6 × 1.5 + 1 × 1.5 Z = 0.36 + 0.33 + 0.66 + 0.9 + 1.5 = 3.75 Interpretation: Z > 2.99, so the company is in the "safe" zone, signalling low bankruptcy risk.
FINANCIAL COVENANTS AND COVENANT STRESS
Credit agreements, especially with banks and bondholders, commonly contain financial covenants. These are designed to act as early warning systems for lenders.
Types of Covenants
- Maintenance covenants: Require ongoing adherence to thresholds (e.g., minimum net worth, maximum gearing)
- Incurrence covenants: Restrict new actions unless a ratio is satisfied at the transaction date (e.g., issuing additional debt).
Typical examples:
- Minimum interest cover
- Maximum debt/EBITDA ratio
- Minimum current ratio
Key Term: covenant stress
The situation where a company is at risk of breaching (or has breached) one or more financial covenants attached to debt agreements.
Covenant Violations
Breaching a covenant can have serious implications:
- Lender may demand immediate repayment ("loan recall")
- Restrictions on dividends, new borrowings, or asset sales
- Damage to credit rating and loss of access to further finance
Not all breaches lead to immediate default. Lenders may grant waivers or modifications—depending on outlook and management credibility.
Worked Example 1.2
A company has an interest cover covenant requiring it to maintain a minimum coverage of 3.0x. Last year, EBIT was $2.4m and finance charges were $0.8m. This year, EBIT fell to $1.5m with unchanged finance costs.
Is the company in covenant stress? What are the potential consequences?
Answer:
New interest cover = 1.5m / 0.8m = 1.88x, below the 3.0x threshold. The company is in breach and at immediate risk of loan recall. The lender may negotiate, demand repayment, or impose new conditions. Inability to comply could result in restructurings or insolvency proceedings.
Exam Warning
Breaching covenants is not always an event of automatic default but may significantly reduce management’s bargaining power. Always check the specific terms of the loan agreement.
USING EARLY WARNING SIGNALS AND TAKING ACTION
Effective managers monitor both quantitative and qualitative signals:
Quantitative:
- Declining liquidity
- Negative free cash flow
- Repeated falls in gross or net margin
- Rising gearing, interest cost, or reduced interest cover
Qualitative:
- Deteriorating supplier or customer relationships
- Resignations of senior personnel
- Qualified audit reports or going concern warnings
- Change in competitive environment or regulatory actions
Timely action may include: engaging with lenders early, reviewing strategy, disposing of assets, cutting costs, or seeking equity investment.
Worked Example 1.3
The board receives notice of a covenant breach due to a sharp inventory build-up and weaker sales. What should management do immediately?
Answer:
Management should notify the lender, prepare a detailed cash flow and restructuring plan, propose remedial actions, and request a waiver or amendment. Quick and transparent communication is valued by finance providers.
Revision Tip
Focus on understanding the meaning behind ratio movements—pair ratio analysis with narrative explanations of what drives the numbers.
Summary
Early identification of financial distress allows time to prevent failure. Prediction models and monitoring of covenants help spot risk before it becomes critical. Financial covenants, if properly monitored, give a clear signal to address problems. Transparent engagement with financiers and credible remedial plans can avoid costly default or insolvency.
Key Point Checklist
This article has covered the following key knowledge points:
- Recognise main causes and signs of corporate failure
- Apply key failure prediction models, including Altman Z-score
- Explain the function and types of financial covenants in debt agreements
- Assess the implications and management of covenant stress
- Identify and act on early warning signals of financial distress
- Develop practical response strategies for covenant breach situations
Key Terms and Concepts
- financial distress
- financial covenant
- failure prediction model
- interest cover
- covenant stress