Corporate failure p5

 

1      Introduction

 

So far we have focused on how effective performance management and measurement can help an organisation in achieving its goals. However, not all businesses will achieve their goals successfully. If left unchecked, these businesses are at risk of corporate failure. It is imperative that steps are taken to identify the potential symptoms of failure and address any issues before corporate collapse occurs.

 

occurs when a company cannot achieve a satisfactory return on capital over the longer-term. If unchecked, the situation is likely to lead to an inability of the company to pay its obligations as they become due. The company may still have an excess of assets over liabilities, but if it is unable to convert those assets into cash it will be insolvent.

 

2      Why do companies fail?

 

Test your understanding 1

 

 

 

Required:

 

Identify some of the reasons for corporate failure.

 

There are many reasons why businesses fail. Two key reasons include:

 

• failing to adapt to changes in the environment

 

• strategic drift, i.e. a rigid approach to strategic planning. Strategy is developed in accordance with unchanged assumptions (which may have proved successful in the past) and may drift away from environmental fit.

 

Failing to adapt and strategic drift

 

 

 

Reasons include:

 

• Failing to adapt to changes in the environment Reasons for failing to adapt include:

 

–    complacency

 

–    risk-averse decision making

 

–    economies of production and administration

 

–    limited opportunities for innovation and diversification

 

–    limited mental models.

 

Complacency is a charge frequently levelled at managers, and there are, no doubt, occasions when senior managers convince themselves that everything is fine, when it is not. However, the charge is frequently made with the benefit of hindsight, rather than observation of the efforts made by those managers at the time. There are several entirely sensible reasons why managers are reluctant to make large strategic changes.

 

First, it is not possible to quantify the risks of making a major change. Several studies have shown that predicting changes in the environment and devising appropriate counter-measures is among the most difficult things a manager is required to do. Only in hindsight are the dynamics clear. It is worth remembering that case studies are written backwards, where a known outcome is traced back to its origins.

 

Faced with such difficulties, managers are reluctant to make large-scale changes that might risk increasing the problems, and might be very difficult to implement adequately. Rather, they select options of relatively limited impact – a process referred to as logical incrementalism.

 

Secondly, changes to production can reduce the opportunities for economies of scale, and raise the firm’s cost base. There is always a temptation to try to retain share, by reducing price, rather than make fundamental changes to a product of its method of production and risk escalating costs.

 

Thirdly, it may be that management is entirely aware that the strategic situation is worsening, but be unable to see opportunities to innovate or diversify out of trouble. It must be accepted that there are situations where there are no feasible solutions, and there might be better uses of the shareholders’ funds than attempts to turn the business round.

 

Finally, a large part of the problem is caused by the mental models of those who have control of the strategy within an organisation.

A mental model is the way that individuals think about problems and issues. We look (below) at Johnson’s notion of strategic drift, where the firm’s mental models stop the company from changing quickly enough to keep up with environmental change.

 

• Strategic drift

 

Strategic drift is a term devised by Johnson (1988) to describe as a warning to those who champion the idea of strategy emerging as a series of logical, incremental steps. Johnson argues that this limits the rate of change to the speed at which management might feel comfortable, which has many advantages (particularly in implementation), but might be inappropriate in periods when the environment moves very quickly.

 

As outlined above, the organisation takes a series of logical, incremental steps that enables it to change ahead of the market, developing a competitive advantage. However, the rate of change in the market place speeds up, and the firm’s incrementalist approach is not enough to maintain its advantage, and it is left behind. At this point, the firm must abandon the approach, and adopt radical, discontinuous change in order to stay with the market leaders.

 

Johnson’s main argument is that the reasons for failing to increase the tempo of change are largely cultural, rather than technical. He argues that the corporate paradigm, as revealed by its cultural web and described in an earlier  , is the biggest constraint on strategic thinking and action. It is important to see that management cannot change a corporate paradigm, partly because they are themselves caught up in it, and partly because some elements of it are not amenable to management techniques. Logical incrementalism is successful because it does not challenge the underlying paradigm, allowing change to take place relatively smoothly. More revolutionary change must damage the paradigm before it can begin.

 

Illustration 1 – Administration of British Home Stores (BHS)

 

 

 

BHS, the 88 year old UK department store chain, collapsed in 2016 resulting in the loss of 11,000 jobs. So what went wrong? Potential reasons cited for the company’s demise include:

 

• Product – a failure to respond to changing tastes and intensification of competition on the high street.

 

• Stores – these were tired looking and compared unfavourably to other department chains.

 

• Pension deficit – the deficit was greater than the schemes assets meaning that the retailer was unable to find buyers for the business as a whole.

 

• Rent increases – the company was locked into long contracts paying considerably above the market rate for rent in many of its 164 stores.

 

• Poor decision making? Questions have been raised over the ability of the owners to breathe new life into the business, for example the brand and product portfolio was repositioned unsuccessfully.

 

3         Symptoms of failure

 

The following information can be used when assessing the likelihood of corporate failure:

 

Quantitative information			Qualitative information
•	Analysis of the company		•	Information in the chairman’s
	accounts to identify problems			report and the director’s report
	relating to key ratios such as			(including warnings, evasions
	liquidity, gearing and profitability.			and changes in the composition
•	Other information in the			of the board since last year).
			•
	published accounts such as:			Information in the press (about
	–	very large increases in		the industry and the company or
				its competitors).
		intangible fixed assets
			•	Information about environmental
	–	a worsening cash position
				or external matters such as
		shown by the cash flow
				changes in the market for the
		statement
				company’s products or services.
	–	very large contingent
		liabilities
	–	important post balance
		sheet events.

 

Test your understanding 2

 

 

 

Required:

 

You have been asked to investigate a chain of convenience stores and assess the likelihood of corporate failure. What would you include in your analysis?

 

 

Additional example on symptoms of failure

 

 

 

Insureme was the market leader in home and motor vehicle insurance with a 28% market share. The company has lost its market share over the last two years and this may lead to the demise of the company.

 

Required:

 

Discuss five performance indicators, other than decreasing market share, which might indicate Insureme might fail as a corporate entity.

 

Solution:

 

Poor cash flow

 

Poor cash flow might render an organisation unable to pay its debts as and when they fall due for payment. This might mean, for example, that providers of finance might be able to invoke the terms of a loan covenant and commence legal action against an organisation which might eventually lead to its winding-up.

 

Lack of new production/service introduction

 

Innovation can often be seen to be the difference between ‘life and death’ as new products and services provide continuity of income streams in an ever-changing business environment. A lack of new product/service introduction may arise from a shortage of funds available for re-investment. This can lead to organisations attempting to compete with their competitors with an out of date range of products and services, the consequences of which will invariably turn out to be disastrous.

 

General economic conditions

 

Falling demand and increasing interest rates can precipitate the demise of organisations. Highly geared organisations will suffer as demand falls and the weight of the interest burden increases. Organisations can find themselves in a vicious circle as increasing amounts of interest payable are paid from diminishing gross margins leading to falling profits/increasing losses and negative cash flows. This leads to the need for further loan finance and even higher interest burden, further diminution in margins and so on.

 

Lack of financial controls

 

The absence of sound financial controls has proven costly to many organisations. In extreme circumstances it can lead to outright fraud (e.g. Enron and WorldCom).

 

Internal rivalry

 

The extent of internal rivalry that exists within an organisation can prove to be of critical significance to an organisation as managerial effort is effectively channelled into increasing the amount of internal conflict that exists to the detriment of the organisation as a whole. Unfortunately the adverse consequences of internal rivalry remain latent until it is too late to redress them.

 

Loss of key personnel

 

In certain types of organisation the loss of key personnel can ‘spell the beginning of the end’ for an organisation. This is particularly the case when individuals possess knowledge which can be exploited by direct competitors, e.g. sales contacts, product specifications, product recipes, etc.

 

4            prediction models

Quantitative models

 

	Model	Explanation
	Beaver’s	A simple, but flawed, model that assesses the financial
	univariate model	status of a company by reviewing one ratio at a time.
	(1966)
	The Z score	A more sophisticated model that combines key ratios into
	(1968)	a single discriminate score. This is a key model and will be
		discussed in more detail below.
		415

 

 

 

 

 

Taffler and	Developed their own version of the Z score model based
Tishaw’s model	on a combination of four ratios.
(1977)
The ZETA model	This model addressed some of the problems associated
(1977)	with the Z score model.
Performance	Ranks all company Z scores in percentile terms,
analysis score	measuring relative performance from 0 to 100. Any
	downward trend over time should be investigated.
H score model	Similar to the previous model in that it is a ranked
	percentile score of between 0 and 100. The threshold is
	25, below which companies are described as being in the
	‘Warning Area’. This score means that only 25% of
	companies have characteristics even more indicative of
	failed companies and therefore corporate failure is a real
	concern.

 

The Z score

 

The Z score model uses publicly available financial information about an organisation in order to predict whether it is likely to fail within a two year period.

 

The Z score is generated by calculating five ratios, which are then multiplied by a pre-determined weighting factor and added together to produce the Z score. The formula is:

 

Z score = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5 Where:

 

X1 = working capital/total assets

 

X2 = retained earnings/total assets

 

X3 = earnings before interest and tax/total assets

 

X4 = market value of equity/total liabilities

 

X5 = sales/total assets

 

The score indicates the likelihood of failure:

 

• Less than 1.81 – companies with a Z score of below 1.81 are in danger and possibly heading towards bankruptcy.

 

• Between 1.81 and 2.99 – companies with scores between 1.81 and 99 need further investigation to assess the likelihood of failure.

 

• 3 or above – companies with a score of 3 or above are financially sound and are expected to survive.

 

 

Test your understanding 3

 

 

 

Required:

 

Using the data below calculate the Z score for each of the four companies and comment on your findings.

 

		Company	Company	Company	Company
		B	C	D	E
X1	= Working	0.717	0.06	1.3	0.25
Capital/Total assets
X2	= Retained	0.847	0.03	0.8	0.21
earnings/Total assets
X3	= EBIT/Total assets	3.107	0.09	1.1	0.5
X4	= Market value of	0.42	0.541	–	–
Equity/Total liabilities
X5	= Sales/Total assets	0.998	–	0.5	0.16

 

Evaluation of quantitative models

 

The advantages of quantitative methods are:

 

• Calculations are simple

 

• An objective measure of failure is provided. However, limitations include:

 

• The prediction of failure for firms with a score below 1.8 (or indeed success for firms with a score of 3 or above) is highly probable but not guaranteed.

 

• The model is based on a statistical analysis of historic patterns of trading by a group of US companies and may not be relevant unless the company under examination falls within the same economic circumstances and industry sector as those used to set the coefficients in the model.

 

• Further analysis is needed to fully understand the situation, e.g. cash flow projections, detailed cost information, environmental review.

 

• Scores are only good predictors in the short-term.

 

• The world economy has changed significantly since the development of this model (the data is now 50 years old).

 

• Figures are open to manipulation through creative accounting which can be a feature of companies in trouble.

 

• The Z score model only gives guidance below the danger level of 1.81. Further investigation is needed for those organisations with scores between 1.81 and 2.99.

 

 

 

4.2 Qualitative models

 

Qualitative models are based on the realisation that financial measures are limited in describing the circumstances of a company.

 

The models use a variety of qualitative and some non-accounting factors to predict corporate failure.

 

The types of factors included are management experience, dependence on one or few customers or suppliers, a history of qualified audit opinions or an uncertain business environment in terms of the industry sector and/or the general economic situation.

 

Argenti’s A Score

 

The most notable qualitative model is Argenti’s A score model.

 

The model suggests that there are three connected areas that indicate likely failure; defects, mistakes made and symptoms of failure. Each of these areas is divided into further headings and scores are given under each of these headings.

 

Argenti suggested that the failure process follows a predictable sequence:

 

• Defects – include management weaknesses (such as an autocratic chief executive, the failure to separate the role of the chairman and chief executive, a passive board of directors, a poor record of responding to change in the business environment or poor skills and experience of the management team) and accounting deficiencies (such as no budgetary control or lack of cash flow planning and/or costing systems). Each defect is given a score. A mark of 10 or more out of a possible 45 is considered unsatisfactory.

 

• Mistakes – will occur over time as a result of the defects above. Mistakes are scored under three headings; high gearing, overtrading or failure of a big project. A score of more than 15 out of a possible 45 is considered unsatisfactory.

 

• Symptoms of failure – mistakes will eventually lead to visible symptoms of failure, e.g. deteriorating ratios, creative accounting or non-financial signs such as delayed investment, frozen salaries, falling market share or high staff turnover.

 

If the overall score is more than 25, the company has many of the signs preceding failure and is therefore a cause for concern.

 

The scores in the three areas themselves are also of interest. For example, a high score in mistakes may indicate poor management.

 

Failing companies often score highly, around 60.

 

Evaluation of qualitative models

 

The key advantages of these models are:

 

• the ability to use non-financial as well as financial measures

 

• the ability to use the judgement of the investigator.

 

However, these strengths can also be seen as weaknesses since the models:

 

• are based on the subjective judgement of the expert

 

• require a large amount of financial and non-financial information.

 

5         Performance improvement strategies

 

The key to preventing corporate failure is to spot the warning signs early, and take corrective action quickly.

 

The actions needed depend on the particular situation. Once the signs of impending failure are seen, it is important to investigate and identify the causes.

 

These may be related to a range of different functions within the business, such as financial management, marketing or production.

 

It may sometimes be necessary to seek external advice to help to identify the problem.

 

It is important that the managers of the business accept that there is a problem and that mistakes have been made and to move on to a solution, rather than apportioning blame.

 

Many actions are available. Examples include:

 

• Major strategic change, such as getting out of a loss-making business, or making changes to the way operations are managed, such as changes to production management.

 

• Implementing controls to prevent further loss.

 

• Acquiring or developing new business (if resources allow) so as to spread the risk.

 

• Ensuring that the different parts of the business are in different stages of the life cycle or that there is a balanced portfolio (as per the BCG matrix) in order to ensure that cash flow is managed effectively and that the business survives.

 

• Learning from mistakes (either their own or their competitors), such as over-priced acquisitions or large project failures, by performing due diligence and risk assessment in advance of the investment.

 

• Managing major risks, such as fluctuations in commodity prices or foreign exchange rates, by using hedging techniques.

 

The best strategy to prevent failure is to have effective management systems in place to begin with.

 

 

6      The performance management system

 

The performance management system will need to reflect the performance improvement strategies:

 

• a link should be established between the new strategic goals and CSFs and KPIs

 

• performance targets should be set at all levels and these should relate to the achievement of strategic objectives

 

• continuous review of actual performance against targets will be required

 

• additional training and development needs must be met.

 

Test your understanding 4

 

 

 

You have been asked to recommend actions which need to be taken to prevent failure of an electronics manufacturer which is in financial difficulties. On investigation, you ascertain that the company has been making losses for the last two years. Although the product is well thought of in the market, sales are decreasing slightly. Returns and customer complaints are high. The manufacturing time for the products is 30 days and raw materials inventories are generally held for two weeks. There are also high levels of finished goods inventories. Receivables days are 100.

 

Required:

 

What actions do you suggest should be taken?

 

7      Long-term survival and the product life cycle

Classic life cycle

 

 

 

The ‘classic’ life cycle for a product has four phases, with different CSFs.

 

• An introduction phase, when the product or service is first developed and introduced to the market. Sales demand is low whilst potential customers learn about the item. There is a learning process for both customers and the producer, and the producer might have to vary the features of the product or service, in order to meet customer requirements more successfully.

 

• A growth phase, when the product or service becomes established and there is a large growth in sales demand. The number of competitors in the market also increases, but customers are willing to pay reasonably high prices. The product becomes profitable. Variety in the product or service increases, and customers are much more conscious of quality issues.

 

• A maturity phase, which might be the longest stage in the product life cycle. Demand stabilises, and producers compete on price.

 

• A decline phase, during which sales demand falls. Prices are reduced to sustain demand and to slow the decline in sales volume. Eventually the product becomes unprofitable, and producers stop making it.

 

Long-term survival necessitates consideration of life-cycle issues:

 

Issue 1: There will be different CSFs at different stages of the life cycle.

 

In order to ensure that performance is managed effectively KPIs will need to vary over different stages of the life cycle.

 

Issue 2: The stages of the life cycle have different intrinsic levels of risk:

 

• The development and introduction periods are clearly a time of high business risk as it is quite possible that the product will fail. Revenues will be low and expenditure high.

 

• The risk is still quite high during the growth phase because the ultimate size of the industry is still unknown and the level of market share that can be gained and retained is also uncertain.

 

• During the maturity phase the risk decreases. Revenues will be high and total assets will be static or decreasing.

 

• The final phase should be regarded as low risk because the organisation knows that the product is in decline and its strategy should be tailored accordingly. However, costs such as decommissioning costs may be incurred during this stage.

 

Understanding and responding to these risks is vital for the future success of the organisation.

 

If there is an analysis of the developing risk profile it should be compared with the financial risk profiles of various strategic options, making it much easier to select appropriate combinations and to highlight unacceptably high or low total risk combinations. Thus for an organisation to decide to finance itself with debt during the development stage would represent a high total risk combination.

 

It will be the scale of financial resources which the organisation calls on over the life of its products which will dictate its survival.

 

Student accountant articles: visit the ACCA website, www.accaglobal.com, to review the article on ‘business failure’.

 

8      Exam focus

 

Exam sitting	Area examined	Question	Number
		number	of marks
December 2014	Quantitative models, life-cycle	4	20
	issues, reducing probability of failure
December 2012	Qualitative models	4	11
December 2010	Corporate failure	5	15
December 2007	Indicators of corporate failure	5(b)	10

Test your understanding 1

 

 

 

Reasons include:

 

• Poor leadership leading to poor business planning, financial planning, marketing and management.

 

• Failure to focus on a specific market because of poor research.

 

• Failure to control cash by carrying too much stock, paying suppliers too promptly, and allowing customers too long to pay.

 

• Failure to control costs ruthlessly.

 

• Failure to adapt your product to meet customer needs.

 

• Failure to carry out decent market research.

 

• Failure to build a team that is compatible and has the skills to finance, produce, sell and market.

 

• Failure to pay taxes.

 

• Failure of businesses’ need to grow, merely attempting stability or having less ambitious objectives.

 

• Failure to gain new markets.

 

• Under-capitalisation.

 

• Cash flow problems.

 

• Tougher market conditions.

 

• Poor management.

 

• Companies diversifying into new, unknown areas without a clue about the costs.

 

• Company directors spending too much money on frivolous purposes thus using all available capital.

 

Test your understanding 2

 

 

 

Examples of issues to include:

 

• an analysis of key ratios, such as liquidity, gearing, cash flow and activity ratios, including trends

 

• changes in the cash flow of the business

 

• any history of significant losses

 

• liability position

 

• ability to pay creditors on time

 

• human resources, for example level of dependence on key staff, labour difficulties

 

• skills and abilities of senior management and an assessment of the strengths and weaknesses of the company

 

• developments in the market, such as the likelihood of new supermarkets being built near stores

 

• any regulatory changes which are likely to affect the company

 

• an analysis of the company report to identify any significant changes over the year.

 

 

Test your understanding 3

 

 

 

	Company B	Company C	Company D	Company E
1.2X1	0.86	0.07	1.56	0.3
1.4X2	1.19	0.04	1.12	0.29
3.3X3	10.25	0.3	3.63	1.65
0.6X4	0.25	0 .32	0	0
1.0X5	1	0	0.5	0.16
Z score	13.55	0.74	6.81	2.4

 

Companies with a Z score of below 1.81 are in danger and possibly heading towards bankruptcy, i.e. company C.

 

A score between 1.81 and 2.99 means that they need further investigation, i.e. company E.

 

A score of 3 or above companies are financially sound, i.e. companies B and D.

 

Test your understanding 4

 

 

 

The evidence suggests that the company has problems in financial management, production, purchasing and marketing.

 

Actions required:

 

• Improve credit control to reduce the debtor days.

 

• Address the production process to:

 

– reduce manufacturing time and stock levels to reduce the requirement for working capital and save costs. This should also improve the ability to respond to customer demands and reduce the need to hold stocks of finished goods

 

– improve final product quality to reduce returns and improve customer satisfaction.

 

• Improve marketing activity to address customer satisfaction issues and increase sales.