Yet the key to whether a firm is likely to emerge successfully is predicated on its projections. Thus, an understanding of the likelihood of over- or underestimating these projections is of primary importance to each of the parties evaluating the projections.

As in the case of Best Products Co., a catalogue showroom operator, both analysts and the company were optimistic about its post-emergence prospects. Company trends looked promising, its post-bankruptcy balance sheet was healthy, and the company was modestly valued. Yet because of a number of market factors, including stiff competition from non-catalogue retailers such as Wal-Mart, Best's performance never kept pace with its projections, and in 1996, six years after its first filing, Best filed for chapter 11 a second time.

The reliability of post-bankruptcy projections continues to receive much attention by attorneys, judges, analysts and other financial/legal professionals. Nevertheless, there has been little systematic analysis of these projections.

According to §1129(a)(11) of the Bankruptcy Code, debtors emerging from chapter 11 must demonstrate the feasibility of their reorganization. That is, the debtor must show that it will be able to operate successfully on its own, without reentering chapter 11. While the specifics of the projections are not detailed in the Code, the debtor typically provides projections associated with its balance sheet, income statement and statement of cash flows. Yet, there is wide variation in the details provided by the company, with the company sometimes presenting them in a highly aggregated format. Typically, however, the categories projected are similar to those provided in the company's financial statements, with the projections often spanning a period of five years, using annual data. Support for the projections includes prevailing economic conditions, likely sales growth, SG&A, taxes, NOLs, and the date the debtor is likely to emerge from bankruptcy. In the disclosure statement, which usually contains the firm's projections and is submitted to the court, the "reorganization value," sometimes called "enterprise value," is also provided. This value is typically provided by the debtor and determined by the debtor's financial advisor. The projections themselves are provided by the debtor's financial advisors.

The Study

We conducted an analysis of the accuracy of projections submitted to the bankruptcy courts as part of a firm's reorganization plan and, in particular, its disclosure statement(s). These were firms that filed for chapter 11 between January 1989 and December 1991, emerging from bankruptcy prior to the end of 1994. The firms analyzed emerged as public companies with actual operations. Moreover, following their emergence from chapter 11, there were two to five years of actual performance data available. The resulting database included a sample of 35 companies. Based on the dates of the sample, all companies in the sample were aware of the 1990-91 recession before being confirmed out of bankruptcy. The data were obtained from both SEC filings and disclosure statements filed with the courts and from The Bankruptcy Datasource, maintained by New Generation Research.

To assess the reliability of the projections, we determined the deviations of the projections from actual results for each year of available data. Based on these deviations, we classified the actual results as either "good news" or "bad news." Actual results greater than projected figures were classified as good news for the following factors: net sales, net income, cash flow from operations, current assets, total assets and stockholders' equity. When actual results were smaller than those projected, it was considered good news for current liabilities, long-term debt and total debt. However, some variables proved somewhat ambiguous to interpret. For example, current assets exceeding projections can be considered good news when sales exceed projections, but bad news if the company fails to effectively collect its accounts receivable.

The Results

The proportion of observations in the sample resulting in good news and bad news was assessed in each year following a firm's emergence from bankruptcy. The results were demonstrative and conclusive.

Bad news dominates good news in each year of the sample, with the results particularly strong in the two to three years following emergence from chapter 11. In the first year, each of the variables, with the exception of current assets and long-term debt, already demonstrated a greater degree of bad news than good news. By the second year, all variables demonstrated more bad news than good news. Similar results were exhibited in the third year. For example, in the third year, 85 percent of the companies reported the actual stockholders' equity as less than that projected.

The results are consistent from year to year, with such key variables as net sales, net income, cash flow from operations and stockholders' equity all demonstrating bad news in each of the years. Indeed, for all years analyzed and for a preponderance of the variables, more than 60 percent of the companies reported bad news. Moreover, for many of the variables, the proportional differences between the firms generating good and bad news was statistically significant.

For virtually all of the data, the mean deviations of actual from projected dramatically exceeded the median deviations. For example, the mean bad news relating to cash flow from operations was -41.6 percent, while the median was -26.4 percent. In other words, the surprisingly poor actual results were dominated by several sizeable debtors. Yet it is evident that the median deviations from projections, reflecting typical deviations, also reflected bad news. The results provide ample evidence that, in the first year following a firm's emergence from chapter 11, the typical firm is already less profitable than expected and has less cash flow than expected. As the years following emergence increase, the deviations between actual results and projections increase and, for most, demonstrate significant consistency in the sign of the deviations for a two-year period.

Deviations from predictions for stockholders' equity can be observed in the table below, which contains data for 26 companies reporting stockholders' equity data. The table below contains five companies in the upper right, two in the lower right, 16 in the lower left and three in the upper left. These results indicate that bad news in stockholders' equity in the first year is likely to result in bad news in the second year, and good news in the first year is likely to result in good news in the second year. In other words, of the 19 companies with unexpectedly poor sales in the first year (lower left and upper left quadrants), 16 firms had unexpectedly poor results in the second year following emergence from chapter 11. The results are even more striking for the second year vs. the third year.

The Conclusions

The results demonstrate that the operating and financial projections provided to the bankruptcy court prior to a firm's emergence from bankruptcy are often overstated and misleading. Moreover, the overstatements are often sizeable. However, it is important, given the uniqueness of the bankruptcy process, not to generalize these results to other situations such as mergers, acquisitions or leveraged buyouts where management also provides projections.

Footnotes

¹ The authors thank Walker Kinman for his valuable research assistance. For a more detailed description of the issues in this article, see Michel, A., Shaked, I., and McHugh, C., "After Bankruptcy: Can Ugly Ducklings Turn into Swans?" Financial Analysts Journal, May/June 1998. Return to article