What is Debtor-in-Possession Financing ?

980 reads · Last updated: December 5, 2024

Debtor-in-possession (DIP) financing is a special kind of financing meant for companies that are in bankruptcy. Only companies that have filed for bankruptcy protection under Chapter 11 are allowed to access DIP financing, which usually happens at the start of a filing.DIP financing is used to facilitate the reorganization of a debtor-in-possession (the status of a company that has filed for bankruptcy) by allowing it to raise capital to fund its operations as its bankruptcy case runs its course. DIP financing is unique from other financing methods in that it usually has priority over existing debt, equity, and other claims.

Definition

Debtor-in-Possession (DIP) financing is a special type of financing designed for companies undergoing bankruptcy. Only companies that have filed for bankruptcy protection under Chapter 11 can obtain DIP financing, which typically occurs early in the filing process. DIP financing is used to facilitate the restructuring of the debtor-in-possession (the status of a company that has filed for bankruptcy), allowing it to raise funds to finance its operations until its bankruptcy case is resolved. Unlike other financing methods, DIP financing usually takes precedence over existing debts, equity, and other claims.

Origin

DIP financing originated from Chapter 11 of the U.S. Bankruptcy Code, which was enacted in 1978 to help financially distressed companies reorganize rather than liquidate. The concept of DIP financing has evolved with the bankruptcy law, becoming a crucial tool for companies to maintain operations during bankruptcy.

Categories and Features

DIP financing is mainly divided into two categories: secured financing and unsecured financing. Secured financing typically involves using the company's assets as collateral, providing lenders with higher security. Unsecured financing does not require collateral but usually comes with higher interest rates. A notable feature of DIP financing is its priority over other debts, making it attractive to investors due to its higher repayment priority in bankruptcy liquidation.

Case Studies

A typical case is the 2009 bankruptcy restructuring of General Motors. After filing for Chapter 11 bankruptcy protection, GM received approximately $30 billion in DIP financing from the U.S. government. This funding helped GM maintain operations during restructuring and eventually emerge successfully from bankruptcy. Another case is Hertz in 2020, which filed for bankruptcy after the COVID-19 pandemic devastated the travel industry. Hertz secured $1.65 billion in DIP financing to support its operations during bankruptcy.

Common Issues

Common issues investors face when considering DIP financing include misunderstandings about its priority, often thinking it is similar to ordinary debt. In reality, DIP financing has a higher priority in bankruptcy liquidation. Additionally, investors may underestimate the risks associated with the successful restructuring of a bankrupt company, so they need to carefully evaluate the company's restructuring plan and market conditions before investing.

Suggested for You

Activity Ratios

An activity ratio is a type of financial metric that indicates how efficiently a company is leveraging the assets on its balance sheet, to generate revenues and cash. Commonly referred to as efficiency ratios, activity ratios help analysts gauge how a company handles inventory management, which is key to its operational fluidity and overall fiscal health.

Accounting Profit

Accounting Profit, also known as Financial Profit or Book Profit, is the net income of a business for a specific accounting period, calculated according to accounting standards. It is derived by subtracting total expenses from total revenues and is typically reported in financial statements, particularly the income statement (profit and loss statement). Accounting profit includes all realized revenues and incurred expenses but excludes unrealized gains or potential losses. It reflects the financial performance and operational results of a business and is a crucial indicator for assessing profitability. Accounting profit differs from economic profit, which considers opportunity costs and implicit costs, whereas accounting profit is based solely on actual transactions recorded.

Accounting Method

An accounting method refers to the rules a company follows in reporting revenues and expenses. The two primary methods of accounting are accrual accounting (generally used by companies) and cash accounting (generally used by individuals).Cash accounting reports revenues and expenses as they are received and paid through cash inflows and outflows; accrual accounting reports them as they are earned and incurred through sales and purchases on credit and by using accounts receivable & accounts payable. Generally accepted accounting principles (GAAP) requires accrual accounting.

Accounting Ratio

An Accounting Ratio, also known as a Financial Ratio, is a ratio derived from data in financial statements used to analyze and assess a company's financial condition, operational efficiency, and profitability. Common accounting ratios include the current ratio, quick ratio, debt-to-equity ratio, gross profit margin, net profit margin, and return on assets. These ratios help investors, management, and other stakeholders understand the financial health and performance of a business. For example, the current ratio measures a company's short-term liquidity, while the net profit margin indicates its profitability. Accounting ratios are essential tools in financial analysis, aiding in making more informed investment and management decisions.

Back-End Ratio

The Back-End Ratio refers to the percentage of a person's monthly gross income that goes towards paying all of their debts. This ratio includes housing expenses (such as mortgage, insurance, and taxes) as well as other debts (such as credit cards, car loans, student loans, etc.). The Back-End Ratio is a key metric used by lenders to assess a borrower's ability to repay a loan. Generally, a lower Back-End Ratio indicates a stronger ability to manage debt, making lenders more willing to extend credit. Typically, lenders prefer a Back-End Ratio that does not exceed 36% to 43%, depending on the type of loan and the lender's policies.

Headline Earnings

Headline earnings refer to a method of reporting corporate earningsbased entirely on operational, trading, and capital investment activities achieved during the previous period. Excluded from the headline earnings figure are profits or losses associated with the sale or termination of discontinued operations, fixed assets or related businesses, or from any permanent devaluation or write-off of their values.