I’m reading other definitions online and it says that it allows companies to restore liquidity & be more flexible. How? What do they mean by more flexible?
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An ELI5 explanation: Let’s say you get a job cutting lawns over the summer. To buy a mower, you go to your best friend and ask him to lend you $200 to buy a mower, and you’ll pay him back next week (along with, say, an extra $10).
You begin cutting lawns, and realize that there’s no way that you can afford to pay him back that fast. So you go to your parents, and ask them for $210, and a payment plan that extends to the end of the summer.
You have just restructured your debt, and avoided pissing off your friend. You are also more flexible, so you might be able to use earned cash to pay a helper.
Debts are restructured when the borrower does not have sufficient cash flow or is at very serious risk of default. Lack of cash flow can cripple an otherwise profitable company – salaries cannot be paid, suppliers stop delivery.
In some cases these cash flow shortages might be temporary (say a project delay) and the company has a good chance of a recovery. Lenders might decide that a restructuring of the debt – delaying payment, extending the term of the loans, reducing interest rates or even partial debt forgiveness is a better option than forcing a company to close down. A company that shuts down typically sells off their assets at very low prices and that may be insufficient to repay the debts.
By working together on a debt restructuring, the company avoids defaults and bankruptcy – freeing up funds that allow them to pull through their difficulties in the short term.
A company that has cash is more flexible – it can fix any product problems, negotiate better prices from suppliers, expand into new markets, complete projects, start new projects etc etc. Without cash or in severe cash shortage, companies cannot hire employees, may be forced to layoff, delay/cancel good projects, mark down and give big discounts just to get faster sales.
Let’s use an individual based example… you have a 15 year, 4% mortgage. You earn $4000/mo, your mortgage is $1500/mo. You see that rates are low, and you not only decide to get a mortgage for 2.8% but you also decide to choose a 30 year mortgage. Now your mortgage drops to $1000/mo. This gives you an extra $500/mo to work with… could simply pay more toward mortgage and still try to pay it off sooner. But you also might want to invest it in stocks. Or use it as a car payment. Or to help cover your new baby’s daycare. You have more flexibility with that money freed up. Companies can similarly use money that would have gone to debt repayment and better invest it in the business by restructuring.
Debt restructuring usually means changing a loan so that:
– You pay back less money (lower interest rate, in some cases lower principal) and/or
– You pay back money over a longer period of time
Debt restructuring can be an ordinary routine move by a financially healthy company. When economic conditions cause interest rates to fall, or when the company’s credit rating improves, it borrows a bunch of money and uses it to repay the loans it already owes. This is a win for the borrower since the new loans have a lower interest rate.
Debt restructuring can also be an extraordinary deal worked out by a financially stressed company and its creditors (banks and other lenders). For example if you run a company that makes $1 million a year, but borrowed $15 million from the bank and is supposed to pay $2 million a year to the bank for the next 10 years. (A very good deal for the bank, as the bank will turn $15 million into $20 million if your company makes all the payments.)
Your company files for bankruptcy. Basically this means you notify all your creditors about your financial problems, break the news that there’s no way you’ll be able to pay them all, and go through a legal process supervised by the court system. You might offer the bank a deal: You pay $1 million a year for the next 10 years instead.
If the bank doesn’t like that deal, the bank does have the option of telling you to pound sand and ask the judge to close your company and sell off the inventory / buildings / etc.
But closing your company might be a whole lot worse for the bank than your offer. If the stuff that would be sold is only worth $2 million or $3 million, the bank might decide that letting you stay in business, and maybe being able to get $10 million over 10 years, is a better bet than forcing you to liquidate and only getting $2-$3 million today.
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